Inflation: Benefits of No Involvement of the Government in Monetary Policy
In 1991, the Italian Parliament approved the “blocco dei beni” law, which introduced the requirement to “seize the goods of the kidnapped, of her/his spouse and of her/his family”. Once in force, this law successfully concluded the tragic season of kidnapping in Italy which plagued the country since the 1970s. This was the immediate effect of a clear and harsh law that nullified any possibility for the victims’ families to pay the ransom, therefore discouraging kidnappers to commit the crime. The key was then a credible commitment by an institution to limit its decision-making power in the future and to manage public expectations of the consequences of the kidnapping. The “blocco dei beni'' law was the first successful measure after a long list of vain attempts with scarce credibility to stop such criminal phenomena. Potential victims’ relatives were prevented from accessing their assets to pay any ransom, which minimized their inclination to collaborate with the kidnappers. This measure solved the strong dynamic inconsistency of this specific issue: even though, ex-ante, the best thing to do is to announce that no ransom will be paid, it is equally true that, once the kidnapping has taken place, the strongest incentive is to collaborate with the kidnappers paying the ransom to avoid the death of the hostage.
In the current period of inflation rise, the crucial importance of reputation in monetary policy is once again a key topic of discussion. The task of Central Banks is guaranteeing price stability and supporting employment, and, in some cases - such as for the European Central Bank (ECB) - the mandate also states a well-defined hierarchy in which price stability has full priority over secondary objectives. This hierarchy is one of ECB’s key strengths to keep inflation under control since it builds its strong reputation and credibility. With the latter, I mean the ability of a Central Bank to tie its hands in advance and to commit to a future behavior in monetary policy. This component of expectations management is crucial because the increase in the general price level of goods and services in an economy (i.e., inflation) is determined jointly by expectations of future inflation of the public, by unforecastable shocks, and by an instrument held by the Central Bank (for simplicity, let’s think of interest rates on mortgages). Hence, when the Central Bank is able to credibly commit to a specified behavior in monetary policy and the public believes it, then the CB consequently has almost full control over inflation[1].
What may undermine the Central Bank's credibility are the interferences of a government aiming at improving its electoral support. In fact, using the interest rates to generate higher-than-expected inflation has a short-term benefit, as it pushes production and output above their "usual" level – just like doping improves athletes’ performance on one occasion – but it has the strong downside of undermining the Central Bank’s reputation as an “independent institution” from the government. This “downgrading” inevitably increases the public’s expectations of inflation in future periods, and therefore creates a dangerous spiral of higher inflation expectations and higher current inflation. Hence, a government concerned to be re-elected and looking to the short term only may regard surprise inflation as a magic stick to improve economic growth. Yet, the public quickly updates its expectations on inflation, and, once this honeymoon of “artificial” growth vanishes, the economy enters a negative spiral of higher inflation. There is a large downside to this “economic doping”, namely that a sustained increase in prices harms the poorest classes because it steadily reduces their purchasing power. In that sense, inflation works like an unfair tax on basic necessities. For this, and for other reasons, price stability is the primary mandate of Central banks[2].
On several occasions, it is possible to explain periods of uncontrolled inflation with crises of Central Banks’ credibility and reputation. Turkey provides a recent example: an invasive and authoritarian State changed the head of the Central Bank 3 times in 2 and a half years (between July 2019 and March 2021), creating enormous instability and difficulty in managing inflation expectations[3]. Probably, the Turkish case can be regarded as a pathological outlier, but similar examples took place in Italy. In 1979, members of the European Economic Community (EEC) took the first significant step towards the adoption of a single currency, by instituting a fixed exchange rate system (European Monetary System). This decision turned out to be an effective move to calm inflation in countries struggling to control market expectations, namely Italy. In fact, the European Monetary System was a credible international agreement, which required the exchange rate between currencies of EEC countries to remain within a pre-established limit. This reduced each State’s chance to carry out devaluation policies with inflationary consequences[4] (Giavazzi and Pagano, 1991), reducing inflation expectations and therefore current inflation.
Evidence presented so far explains the importance of having strong and credible Central Banks to lead their policy-making process which should be totally independent of populist, short-term oriented government pressures. In the 1990s, the State managed to curb the escalation of kidnappings by influencing expectations of future ransoms. Similarly, Central Banks must control inflation expectations to be effective in guiding present inflation: markets (the “public”) are aware of the inflationary temptations that government interventions may induce to fuel economic growth in the short term. This is why the Central Bank must be perceived as independent and able to conduct monetary policy with credibility and with minimum discretion.
As a remark, it is crucial to bear in mind that full commitment to future policy behaviors is not a panacea for Central Banks, as it clearly comes with a cost in terms of flexibility. Interestingly, a few days ago a clear example of this tradeoff was presented by Fabio Panetta, an Italian member of the ECB’s Executive Board. In his speech at the event of the CER (Centre for European Reform) held in London, he expressed his views on future ECB policy moves, warning on the risks that excessive commitment may have in the current uncertain medium-term outlook for inflation. On the one hand, he praised the benefits of conducting monetary policy in a predictable and credible way, adopting a clear response function to inflation dynamics. On the other hand, he highlighted the need for a degree of flexibility to face effectively the future changing economic outlook.
In this regard, Panetta drew from the 1970s Italian musical repertoire, suggesting not to “drive like crazy at night with our headlights turned off” (“Emozioni” - Lucio Battisti), evoking himself a period of Italian history that took center stage in this article.
In conclusion, among the conditions for a stable price increase and healthy economic growth in the long run, there is certainly the marriage of minimum State involvement with an independent Central Bank, which imposes consciously strict rules on itself and follows them to feed its own credibility.
Notes:
[1] In monetary policy, the opposite of credibility is discretion. This attribute refers to policy conduct that responds to single monetary shocks one by one, without having the credibility necessary to take any commitment to future behaviors and thus managing expectations.
[2] There is vast and growing literature on the specific effects that high inflation actually has on the middle and lower classes. The extent to which inflation exacerbates inequalities certainly differs from case to case, and it is based on the specific nature of the rise in inflation. What is certainly true is that higher inflation is perceived with hostility as an unfair tax.
[3] Formally, the Turkish Central Bank has a clear hierarchy among its objectives: “The Bank shall, provided that it shall not conflict with the objective of maintaining price stability, support the growth and employment policies of the Government.” (Article 4 of the “Fundamental duties and powers” of the Turkish Central Bank). Yet in practice, the interferences in monetary policy and the authoritarian stance taken by the government make the situation totally different.
[4] This is because fixing the exchange rate between two countries is a way to improve the credibility of policymakers as it attaches an extra penalty to inflation (in terms of competitiveness losses).
Brief references and suggestions:
- For more information on BCE next moves and the interview to Fabio Panetta of February 16: https://www.ft.com/content/bd98983d-6fd9-4f94-abaa-aa6e11be2a98; his speech in London: Monetary policy after the energy shock (europa.eu).
- Where the idea of reputation and credibility in policymaking first came in: Kydland, F. E., & Prescott, E. C. (1977). Rules Rather than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy, 85(3), 473–491. http://www.jstor.org/stable/1830193
- Brief report on the impact of current inflation rise across socio-economic classes: https://www.ecb.europa.eu/pub/economic-bulletin/focus/2022/html/ecb.ebbox202207_04~a89ec1a6fe.en.html
- Turkish Central Bank Mandate:
https://www.tcmb.gov.tr/wps/wcm/connect/d6ac47f4-379f-43da-bf2b-7ad855dca0ff/The_Law_on_the_Central_Bank_of_the_Republic_of_Turkiye.pdf?MOD=AJPERES&CACHEID=ROOTWORKSPACE-d6ac47f4-379f-43da-bf2b-7ad855dca0ff-nWcODLa
- The case of EMS: Francesco Giavazzi & Marco Pagano, 1991. "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 303-330, National Bureau of Economic Research, Inc.
- A very similar (but older) article to the present one, with more technicalities:
https://www.stlouisfed.org/publications/regional-economist/january-2003/rules-vs-discretion-the-wrong-choice-could-open-the-floodgates