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What 'The Wizard of Oz' Can Teach Us About Inflation

What 'The Wizard of Oz' Can Teach Us About Inflation

Wednesday, 8 December, 2021 - 05:45

Sure, we need to live with the virus. What’s not said enough is that this means being comfortable, or at least adapting to, uncertainty in central bank communication. These officials aren’t epidemiologists and they don’t know where Covid-19 is going. The hand-holding that’s characterized the past two decades is hard to justify, and shouldn’t be expected going forward.There will be some challenging moments as officials and investors adjust to this new paradigm. Policy makers are confronting elevated inflation that’s proving more stubborn than forecast and an on-again, off-again outlook for the recovery. Omicron looks like it will hurt activity and aggravate the supply chain bottlenecks that are keeping the pace of price increases uncomfortably fast. The International Monetary Fund recently foreshadowed cuts to its growth estimates and warned central bankers to be vigilant. It’s tempting to read last rites for forward guidance and a decent chunk of the messaging paraphernalia that determined policy at least since the 2008 fiasco and, arguably, since the turn of the century. How else to explain recent communication shocks in the US, Europe and Asia? Central bankers once invested so heavily in forecasting future actions that the data was almost secondary. The idea was to prevent the market upheavals that came with surprises. But those surprises have been notable lately. Data-dependency looks ascendant.

In retrospect, forward guidance probably only worked smoothly when inflation could be predicted, with a degree confidence, to be relatively low. The idea rested on a world free of upset. Our universe today is anything but.

That is the critical context for understanding not just the jarring pivot from Federal Reserve Chair Jerome Powell last week, but the Bank of England’s shock decision in November to refrain from a rate hike that any middling student of central bank verbiage would have thought very likely. Early last month, traders in Australia were left guessing what officials would do with the three-year bond target after failing to intervene to protect it. In the end, the target was retired. If the board had opted to keep the goal, it would have made for a very awkward monthly statement from Governor Philip Lowe. (The RBA kept policy unchanged Tuesday after its December board meeting; the bank is prepared to be patient on rates and will review its QE program in February.)

There’s a bit of revisionist history going on in the days since Powell’s congressional testimony. Shelving the word “transitory” and flagging the prospect of a faster bond taper have been judged as common sense and the only prudent response to accelerating inflation. But that view also skates over the gap between his comments and the benign tone of his prepared text, which was slightly dovish in its description of omicron. Since the 2013 taper tantrum, which was the result of off-the-cuff remarks offered in testimony by then-Fed boss Ben Bernanke, officials have been at pains not to riff on policy. Make proceedings as boring as possible, the thinking goes. That no longer seems to work.

There’s likely to be more, not less of this uber-responsive, less programmatic approach to conveying policy intent. Omicron may well mean some hit to growth, but don’t expect the dovish pivot or the “central-bank put” to appear per convention. The reason monetary authorities have been able to support growth in the past, almost no matter what, is that inflation has been quiescent. Take that away, and everything else is up for grabs.

Forward guidance was never set in stone. For 2015, the famous Fed dot plots indicated four rate hikes. Only one happened. Similarly, the central bank went into 2016 projecting four increases; again, only one materialized. These stand out because they are the exceptions rather than the rule. On the whole, across jurisdictions, forward guidance — when it has erred — has mostly been to favor easier policy. Officials were always keen to point out that they were engaged in projections, not promises. People largely tuned it out. The tool will live on in some form, but there’s a limit to its credibility. Based on recent events, projecting out mere days or weeks is a good enough guess. We’re now at a moment not unlike the conclusion of “The Wizard of Oz.” The great and powerful voice behind the curtain has been exposed as a small man, furiously tinkering with the levers and dials of a world that’s slipped beyond his control.


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