A new strategy against inflation.

 Column by Francesco Grillo for the Italians newspaper Il Messaggero, Il Mattino, Il Gazzettino del Nord Est.

Economists, bankers and governments often disagree on the European Central Bank’s decisions on interest rates. However, such disagreements should start from an issue that is often underestimated: are central banks actually able to control inflation? This question is of key importance, because if we found out that the answer is no, then we should recognize that we have been trying to fight a virus with a cure that is not working anymore.

This would have significant consequences, because the collateral effects of monetary policies impact on: families who need to pay their mortgages; banks’ balance sheets (considering that some of them are advantaged by higher interest rates and some others are not); the overall economy.

The great doubt on central banks lies in the numbers that have been defining the Western economy in the past 15 years. Immediately after the great financial crisis, from 2009 to 2015, the Federal Reserve (FED) and the European Central Bank (ECB) tripled their budgets injecting 5 trillion into the system. Technically, a system “flooded” by money should experience a galloping inflation but, on the contrary, the inflation rate – that used to be 4% before the operation – was lowered under 0% after this intervention, 6 years later.

The current situation is opposite to the one we had 10 years ago, but the paradox repeats – in reverse. Since last July, the ECB has made interest rates 7 times higher, from 0 to 4%. This should lead to a reduction of prices. However, if we consider domestic inflation (which does not depend on energy and food prices), it increased from 4 to 5,4% during the same period.

These numbers are painful: if the cost of money increases by 4 percentage points, mortgages increase by 60% and families, who already have to face high inflation rates, are affected by further difficulties. Moreover, these numbers seem to contradict one of the few certainties that we usually study in macroeconomics: the feeling is that, in the past 30 years, an external variable intervened to change the link between money, growth and inflation. That external variable is technology, which on the one hand increases exchanges between systems that used to be closed; on the other, disintermediates banks as the only entity creating money.

This is surely relevant for those who want to seriously reason on the future. Three centuries after the first central bank (the Bank of England) was created, what can be the role of central banks? How should the ECB’s mandate change, 25 years after its creation? We can try to answer considering the three objectives that are usually given to a central banker: inflation, financial stability and growth (the so-called “secondary mandates”).

First of all, on inflation, banks need to update one of their strengths: studying, updating measurement tools. This means to better evaluate the effect of the three causes of inflation: technology’s deflating potential and how different societies can absorb technologies; the higher or lower integration of global value chains; the balance between supply and demand inside the economic system governed by the central bank. Such analysis is crucial, because central banks can only influence the third element directly, whereas they can only try to coordinate the other two.

However, a similar evolution also implies letting go of the myth of 2% as a target. Both the ECB and the FED explicitly declare that they want to keep inflation around that level, which was arbitrarily set. Actually, it should not be excluded that, in a situation of high technological progress, an evolved society might even have the objective of maintaining inflation below 0 for a long time.

Secondly, financial stability – which today, as opposed to inflation, is paradoxically even more firmly in the hands of central banks. In Frankfurt, they are working to protect Europe from crises that keep affecting “victims” that seemed too big to fail – in the US and Switzerland. It was Draghi’s ECB to save Italy from financial failure, and Lagarde’s ECB to guarantee for countries whose public debt/GDP ratio, during the pandemic, increased by 15 points. And yet, central banks cannot coordinate more with those who – European Commission, national central banks – have the instruments to prevent bank rescuing from becoming “moral hazard”: the survival of certain governing elites and behaviors that are no longer adequate.

Finally on growth, employment and the environment. Using interest rates for these policies worsens the contradiction we started from: we would use a broad-spectrum antibiotic to tackle very specific issues. And yet, a growth that is too low or damages the environment turns into financial instability and inflation in the medium term. The central bank of the future will have the tools and skills needed to propose new strategies. The institutions that raised great economists can give a decisive contribution - a theory of how economic systems work in the 21st century. However, in order to do so, they have to be brave enough to go beyond mathematic models that are now meaningless.