Like a drunkard walking home from the pub, the world’s monetary authorities stumble from blunder to blunder, making one ill-advised statement after another. You know the kind of thing… “This inflation is transitory. It will be back down to two per cent by the end of the year.” And one of my personal favourites: “We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates.”
And still they come. In April, Ben Broadbent, the Bank of England’s deputy governor, monetary policy, told us that the current inflation cannot have been caused by an increase in the money supply. These are the words he used: “A pure, money-driven inflation affects all prices equally. What we’ve actually seen are huge shifts in relative prices.”
This is interesting. For a moment, I wondered if the Bank was relying either on GCSE economics or on the economic theory of the 1950s. You see, in reality, the first manifestation of a money-driven inflation is disturbances in relative prices. It’s these disturbances that cause the damage. However, the idea that such a highly trained group could be quite so ignorant simply isn’t realistic. So what’s going on?
A couple of days later, another gaffe gave me a clue.
Speaking on a Columbia Law School podcast, the Bank’s chief economist, Huw Pill, gave us some tough medicine: “[People in the UK need] to accept that they’re worse off and stop trying to maintain their real spending power by bidding up prices, whether through higher wages or passing energy costs on to customers etc. What we’re facing now is that reluctance to accept that, yes, we’re all worse off and we all have to take our share.”
There are a few things to say about this. First, it seems pretty tone-deaf and it wasn’t likely to make many friends. Understandably enough, this was the principal take in the media. Secondly, as I pointed out in this magazine two years ago, whenever inflation becomes embedded, everyone looks for someone else, or some other group, to blame. Those on the Right blame excessive wage demands; those on the Left blame greedy corporations. Both are wrong.
The Bank seems to believe it can affect behaviour with words
However, another aspect of Huw Pill’s ill-advised remarks is the window they provide on central bank thinking. The Bank of England seems genuinely to believe that it can affect behaviour with the power of its words. This is complex and I can only scratch the surface here. However, with this we can, I think, better understand the Bank’s sanguinity back in 2021: “We’re not expecting inflation; inflation expectations are well-anchored.”
We can also make sense of Ben Broadbent’s apparently bizarre claim about changes in the money supply and the structure of relative prices. You probably know the Keynes quotation: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
The academic scribbler in this case was the recently deceased Nobel Prize-winning economist, Robert Lucas. Lucas’s great contribution was the insistence on consistency in economic theory. Let me elaborate. How, he asked, was it in any way reasonable to postulate a greater degree of rationality to policy makers than to ordinary citizens?
Before Lucas’s work, the authorities were seen as being able systematically to fool the public; learning from error was thought to happen slowly if at all. As Lucas pointed out, this assumption was arbitrary; it imposed a bounded rationality on the populace but not on the policy makers. Surely, it’s economically rational to learn from our mistakes? Furthermore, we won’t get fooled again. And so, according to Lucas, the next time the authorities make a policy change, everyone will simply adjust their behaviour straight away. In other words, instead of waiting for policy changes to percolate gradually through the economy, they’ll immediately adjust their prices or wages. This was the Rational Expectations revolution. It’s elegant, brilliant, logically consistent and wrong. When rational expectations are used as the basis of an economic forecast, that forecast is almost certainly going to be miles out.
Higher-level economics teaching of the 1980s and 1990s was permeated by the rational expectations approach. This, I believe, is an important factor in the Bank’s woeful economic diagnoses. It also explains why Ben Broadbent thought a monetary inflation would affect all prices simultaneously. Under extreme rational expectations, that would be correct. However, although the extreme rational expectations are an instructive thought experiment, the assumption has absolutely no place in real-world policy making. Wouldn’t it be rational for the central bankers to learn from their mistakes?
Peter Lawlor is the Principal Economic Advisor to 7Ridge Capital and an adviser to senior Wall Street figures. These are strictly his own views
