Are Central Banks still capable of controlling inflation?

Vision Think Tank¹ - March 2023

In the TV series "La Casa de Papel" ("Money Heist"), which made NETFLIX the most powerful competitor to television and film companies, the Professor, who leads the spectacular action to print one billion euros, provides a moral value to what is a theft. Speaking with the police inspector who falls in love with him while chasing him, he explains that, in essence, he and his accomplices were doing what central banks do. Creating money out of nothing, but putting the money into the pockets of real people better than bankers. The conversation makes some significant errors, and yet today the doubt remains: are central banks still able to control inflation? Is it possible that factors such as technology and globalization (or the reverse process of fragmentation) have become more powerful than the solemn decisions that Jerome Powell and Christine Lagarde periodically communicate?

To tell the truth, doubts about the real effectiveness of the tools that central banks have at their disposal to achieve their objectives began precisely when they were called upon to go beyond their top priority mandate to save a financial system, hit by two crises within a few years. The financial crisis of 2008 overwhelmed private banks, forcing the American Federal Reserve (FED) to save them. The crisis of 2011 was about to blow up Greece and Italy when Mario Draghi made the European Central Bank (ECB) the barrier that would save the EURO. From 2009 to 2015, the FED and the ECB injected 5 trillion into the system - an amount of money worth three times Italy's GDP - tripling the size of their balance sheets. And yet the paradox is that if before this colossal operation, inflation was around 4% (in 2009), it had fallen below 0% when the injection ended in 2015. Contradicting what we study in the first-year economics textbooks, because an increase in the quantity of money should result in an increase in inflation. And not its disappearance.

The paradox is of great importance because if we were to realize that the level of prices is no longer controllable by central banks, this would call into question the legitimacy of institutions that exist to control inflation.

Today the situation is the opposite of that experienced ten years ago, but the paradox repeats itself. Inflation is not too low, but it has suddenly become too high, and if ten years ago, someone might have had the impression that we had found a way to print money for free, today we find ourselves in a situation where the increase in interest rates is strangling families already impoverished by inflation. However, central banks still seem powerless: the interest rate that the ECB charges has increased six times since last July and is at 3.5%; inflation continued to rise until November (10.6%), then fell to a level in February (8.5) that is still four times higher than the one (2%) that the ECB must maintain under its statute. Even more alarming is the fact that the small decrease in inflation over the last four months was entirely due to the reduction in the price of energy that we benefited from after surviving Putin's threats. Meanwhile, the price of domestically produced goods and services that should be most influenced by monetary policy continues to rise.

GRAPH, INFLATION AND ECB INTEREST RATE, JANUARY 2021-MARCH 2023

SOURCE: VISION ON EUROSTAT AND ECB DATA

In short, today as ten years ago, it seems that inflation has become indifferent to the decisions of institutions whose objective is to control its level. The European Parliament commissioned a report in 2015 entitled "Has globalization reduced the ability of central banks to control inflation?" And it is, in fact, the progressive integration of goods and capital markets, as well as technology, that has (almost) killed monetary policies. Prices are falling because computers are increasing productivity, and they are rising if the world goes backward. Increasingly less for the decisions of central bankers. Furthermore, this transformation will be further accelerated when technologies - after recent disasters - manage to erode the monopoly that banks and states have on the creation of universally accepted currency.

The consequences of this innovation are very important. We could find ourselves discovering that we are taking expired medicine for a virus that has undergone a mutation that we have not yet had time to study, and that we risk a financial and economic crisis that could have been avoided.

The alternative is the one indicated by the European Parliament report itself: to better study how certain financial storms form, going beyond macroeconomic models that have lost validity; to modify the objectives of central banks making them more flexible and realistic (focusing on domestic inflation, for example); to take on time horizons less focused on newspaper headlines; to coordinate with the central banks of Asian giants - China, India - which are increasingly influential.

It was, after all, Mario Draghi himself who reminded his colleagues that we are sailing in waters for which we do not yet have a nautical map. If we continue to use old tools (interest rates and the quantity of money) for phenomena that are changing, we risk dangerous side effects and making obsolete the institutions to which we entrust the little stability that remains.

^1: The co-authors of this paper are Giorgia Caianiello and Francesco Grillo from Vision Think Tank. The paper has been an input to a column published by Francesco Grillo on the Italian newspaper il Messaggero and Gazzettino del Nord-Est.