A political backlash against monetary policy is looming

Three weeks ago, Finland’s Prime Minister Sanna Marin retweeted a link to an article by a Finnish academic along with the following quote: “There is something wrong with prevailing monetary policy ideas when central banks protect their credibility by pushing economies into recession.”

Defenders of these dominant ideas have been predictably rebuffed and warned against questioning independent central banks or undervaluing their credibility. But defense is the wrong answer. Not only because Marin did not actually criticize central bank actions. But mostly because avoiding a debate about whether our macroeconomic regime is fit for purpose is more dangerous than engaging in one.

Comparisons to the 1970s often overlook an important lesson of the decade: a macroeconomic regime that cannot justify itself is being overthrown, first intellectually, then politically. From the ashes of the currency chaos of the 1970s, theories were born that justified independent central banks with mandates to keep inflation down. Before the end of the century, independent inflation targeting was a must in most advanced economies.

Forty years later, a fresh intellectual and political reckoning would be less surprising than the absence of one. The “great moderation” brought about by the currency revolution of the 1980s has long been accompanied by stagnant wages for low earners in many countries. The glacial recovery from the global financial crisis prompted the world’s two largest central banks to overhaul their policy frameworks during the pandemic. In 2020 and 2021, the Federal Reserve and European Central Bank pledged to tolerate a period of higher inflation if employment needed to keep rising or there was little room for monetary easing in the event of a downturn. But this new attitude failed at the first hurdle.

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With the cost of living crises biting and recessions looming in key advanced economies, what are the odds of avoiding a more thorough reckoning for much longer? Marin is not the only national leader to express unease about central banks. French President Emmanuel Macron recently voiced concern that “pundits and European monetary policymakers are telling us we need to curb European demand to better contain inflation.”

Precisely because central bankers are independent, it falls to political leaders to explain to their citizens why it is right to counter Russian energy blackmail with measures to further crack down on incomes and jobs. They would be remiss if they didn’t question whether this is the best we can do.

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Central bankers, on the other hand, have it easy. They have statutory anti-inflation mandates that they cannot challenge. And they have an argument: Losing their “credibility” – by which they mean people no longer believe they can keep inflation down – will cost even more jobs and lost incomes.

But the credibility of central banks themselves is only as good as the credibility of the macroeconomic regime as a whole. This is not to say that central bank independence should be jettisoned, but to openly ask whether it actually works for the economy.

In pursuing individual mandates, central banks may be too tight collectively, as Maurice Obstfeld has suggested. Or, as Marin has suggested in subsequent comments, monetary policy that is not coordinated with fiscal policy makes matters worse.

The IMF has warned governments against setting budgets “contrary to monetary tightening”. But raising interest rates puts monetary policy at odds with fiscal policy priorities such as investing in the green transition or indeed energy infrastructure, which itself would fix energy-related inflation. While monetary considerations should prevail, such monetary dominance is undoubtedly something that should be democratically debated, not technocratically imposed.

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In fact, central bankers may not be sufficiently independent, yielding to the political pressures that result from each new monthly record in current inflation, rather than coolly focusing on their benign medium-term outlook.

As in the 1980s, shrewd economists will, over time, suggest better ways of framing monetary policy against energy price shocks. And unless we happily escape a sharp downturn this winter, there will certainly be a political backlash as well. The alternative to openly debating these issues in a democratic space is to allow this backlash to smolder until it erupts in the more radical and dangerous form of a populist assault on institutions. The credibility of the central banks would then not be worth much.

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