Why didn’t central banks see inflation coming?

Businesses and consumers can be forgiven for missing the economic signals. The monetary authorities have some explaining to do

July 30, 2022
The Bank of England's forecasts have been "hopelessly wrong." Mark Thomas / Alamy Stock Photo
The Bank of England's forecasts have been "hopelessly wrong." Mark Thomas / Alamy Stock Photo

Inflation is at forty-year highs in Britain and America. In the eurozone, it is the highest since the monetary union was created almost a quarter of a century ago. Only 18 months back, at the start of 2021, consumer prices were barely rising at all: inflation was about 1 per cent in all three economies. Now it is around 9 per cent.

The upsurge in inflation has been a huge shock to businesses facing higher costs and families struggling to make ends meet. Their surprise, after years of low and stable inflation, is understandable. What is harder to understand is that central banks have also been blindsided—even though their main job is to keep a lid on prices by hitting 2 per cent inflation targets.

As the world’s most influential central bank, America’s Federal Reserve plays a particularly important role in setting global monetary conditions. Over the course of 2021, US inflation rose from 1.4 per cent in January to 7 per cent in December. Yet for much of that period, the Fed’s chair Jerome Powell insisted that the rise would be “transitory.” It was only towards the end of the year that the Fed recognised this was wishful thinking.

The Bank of England has also got things hopelessly wrong. Its recent inflation forecasts now make for red faces at the central bank. In May 2021, the Bank projected inflation of 2.3 per cent in a year’s time; instead, it was more than 9 per cent. In November 2021, the BoE expected inflation to rise to around 5 per cent in April 2022, and then to fall back to 3.4 per cent by the end of the year, but last month it predicted a peak of above 11 per cent this October.

One thing that none of the central banks could have anticipated was Russia’s invasion of Ukraine in late February. That has undoubtedly added accelerant to the inflationary fire, most of all through stoking further rises in energy prices. But that fire was already burning fiercely, with the prices of a wide array of internationally traded goods rising across the board. This had happened as household incomes in advanced economies—especially America—were bolstered by fiscal support during the Covid pandemic. Consumers switched their spending from local services such as hospitality to products such as vehicles, which were affected by disruptions to global supply chains.  

It is now clear that central banks miscalculated the risks of inflation following their whatever-it-takes support when output slumped in the spring of 2020 during the pandemic. Those actions, primarily massive purchases of government bonds (a process called quantitative easing), were initially justified but sustained for too long, especially once it became clear in early 2021 that vaccinations provided a way out of lockdowns. The Bank of England, for example, doggedly carried on with quantitative easing throughout 2021 even though the economy recovered more strongly than expected. The European Central Bank has only just ended negative interest rates, an emergency measure introduced eight years ago to prop up a then-sickly eurozone economy.

Using data stretching back to the Black Death in the 14th century, economists at Goldman Sachs found in March 2021 that pandemics—unlike wars—tended to dampen inflation rather than to ignite it. But no previous pandemic prompted the sweeping fiscal and monetary interventions made in response to Covid. That’s what wartime governments do, which is why wars do tend to generate inflation. Conflicts also disrupt production, which adds to inflationary pressures through shortages—just as the pandemic has caused global bottlenecks.

To the extent that central bankers were monetary generals during Covid, they were still fighting the last war—against inflation being too low. In August 2020 Powell unveiled the Fed’s new monetary strategy, shaped by “the persistent undershoot of inflation from our 2 per cent longer-run objective.” The new approach was a signal to markets that the Fed would tolerate a period of above-target inflation without immediately clamping down.

Writing in the Times earlier this month, Paul Johnson of the Institute for Fiscal Studies blamed the prevailing consensus, which was that in the era of independent central banks “we thought we had inflation licked.” But there were dissenters. Johnson cites Lawrence Summers, a Treasury secretary under Bill Clinton and a chief economic adviser to Barack Obama, who in February 2021 warned that Joe Biden’s big fiscal stimulus could trigger “inflationary pressures of a kind we have not seen in a generation.” More presciently still, economists Charles Goodhart and Manoj Pradhan warned in March 2020 of a “surge in inflation” once lockdowns were lifted and recovery got under way, “following a period of massive fiscal and monetary expansion.”

Whatever the forecasting models of central banks were showing, a sense of history and of imagination would have recommended caution about a potential inflationary flare-up. That has been strangely lacking. Central banks may be notionally independent, but central bankers appear to have been anything but independent-minded.