Time for more humility and pragmatism from central banks

In the latest Nordea On Your Mind report, “The return of inflation”, Johan Trocmé (JT) interviews colleague Torbjörn Isaksson (TI), Chief Analyst in Nordea Markets.

Rather than using emergency monetary policy tools such as negative interest rates and quantitative easing (QE) to reach inflation targets, Isaksson suggests central banks should have more flexible consumer price index (CPI) target ranges and be able to weigh other important variables, including resource utilisation, financial stability and home prices.

JT: How would you describe in a simple way what inflation is? How is it defined by central banks, who have the responsibility for controlling it? And how is it measured?

TI: Inflation is the change in prices of the goods and services that households buy. We measure it with a consumer price index, CPI. National statistics agencies closely track household spending, down to the level of how many t-shirts or cookies we typically buy. The various purchases are weighted and aggregated into an index which represents the total price change for household spending.

It is the statistics agencies who define the CPIs, but they use nomenclatures developed by the EU, the OECD and for that matter by the UN. These forums continuously discuss how the indices should be defined and constructed.

There are two types of inflation indices. The first is a cost-of-living index, and the second is a pure price index. For example, in Sweden HIKP is an EU-harmonised price index, while the CPI is a cost-of-living index. The difference between the two is not that great, except regarding housing. This is the most difficult cost item to define and measure. A cost-of-living index tries to capture the cost of having access to a place to live, while a consumer price index aims to measure the cost of buying a new home. Households buying existing homes from each other is not included, only the cost of buying a newbuilt home. I don't know of any country currently using this home purchase cost approach in its main CPI, but there is an ongoing project in the EU involving the ECB and Eurostat to include it in the EU's Harmonised Index for Consumer Prices, HICP. The ECB does monitor the HICP, which will include new home costs in the future, while Sweden's Riksbank focuses on the adjusted fixed interest rate CPI, called CPIF. If housing had been included, Swedish HICP inflation would probably have been 20 bp higher annually during the past ten years. Even with these differences, the inflation measures that central banks use are generally quite similar.

Broadly speaking, national statistics bureaus have a similar approach to defining and measuring inflation. But there are some differences. As an example, in the US, a rent equivalent approach to measure all housing costs is used. In Sweden, actual rents are about 7.5% of the CPI basket. Measuring accommodation costs is quite a complex matter, often subject to debate. Another area of differing views and ambition levels is how to measure changes in quality. Just consider the price of a smartphone. The price for a new model may be higher, but what functionality does it offer compared with the previous model? You may be paying more, but not for an equivalent product. It is not a game changer for the level of inflation, but different approaches could perhaps raise or lower CPI growth by some tens of basis points. The point of using harmonised price indices is for all countries to measure inflation the same way. Within the EU, for example, harmonisation is continuously getting better. But some differences remain. You could describe it metaphorically as not quite being able to compare apples with apples, but comparing different varieties of apples, rather than comparing apples with melons. I think it is impossible to construct a perfect CPI. Discussions on price and quality can easily become quasi-philosophical. For example, ecological tomatoes are normally more expensive than regular tomatoes, but perhaps more nutritious to eat and better for the environment. How do you measure and put a value on that? Healthcare expenses are included in CPI. How do we capture quality of healthcare services improving or deteriorating? I would argue there is something of an exaggerated faith in how precisely our CPIs are able to measure inflation. They are a good tool, for sure. But they give an estimate, not an exact measurement. I find it odd that certain central banks sometimes seem to pay so much attention to small basis point movements in CPIs. The recent upsurge in inflation will hopefully change that.

JT: In what way does high inflation hurt an economy? Can a too-low inflation rate also have a negative impact? Is there an optimal rate of inflation?

TI: Inflation is a natural, inherent part of an economy, and it is a widely accepted view that a certain level of inflation is normal and desirable. A high inflation rate is usually also volatile. This combination of rising and unpredictable prices makes economic planning difficult for households and companies. Will you start a big project when you cannot know what it will cost to complete? Do you want to produce goods at your current costs when you don't know what price you will be able to sell them for? An extremely low inflation rate makes relative price adjustments between goods and services more difficult. It is typically difficult to implement nominal price reductions. With some inflation in the economy, there is often room to raise prices a bit more or a bit less for different products, with the divergence paving the way to a new equilibrium. Holding back on price increases is easier than actually cutting prices.

If inflation is below zero, becoming deflation, there is a risk that demand will suffer, as households opt to postpone consumption. They will wait for a lower price later. But a strong argument against this potential effect is that CPI baskets are quite heavily biased towards everyday goods, including food. These are not so sensitive to expectations of future price changes. The same goes for housing, which is some 25% of the CPI basket, and a proxy for the cost of use rather than the actual price for a new home. The potential 'deflationary fear' hit to consumption would be a bigger thing if baskets had a greater share of big ticket expenditures, most obviously if they had a big direct home price component. It is possible that CPI baskets were a better reflection of a typical household's overall economic transactions 50-100 years ago. Today, consumers are often also shareholders and home owners with quite significant asset values in their personal balance sheets. This can have a big impact on domestic demand.

As for an ideal level of inflation to aim for, I think 2% is reasonable. 1% or 3% would probably also be reasonable. The 2% level is to some degree a coincidence. The central bank of New Zealand was the first to introduce this level as a target, and the rest of the western advanced economies more or less followed suit. There is clearly a benefit in many or most countries having a similar target level. If the key central banks conduct monetary policy pulling in the same general direction, there should be less tension and friction to drive up exchange rate volatility. A 2% inflation rate, perhaps varying by 1-2 pp up and down over time, is typically widely perceived by households and companies as a low and stable inflation rate.

JT: What are the biggest drivers of inflation, the heaviest components in the price index? Are there major differences in how different central banks measure inflation? Are some countries affected more than others by specific drivers?

TI: To begin with, in small, open economies such as the four Nordic countries, inflation is determined globally. Inflation and wages will not rise here, unless they are rising internationally. Labour, goods and services are still flowing fairly freely around most of the world. Most of the goods that Nordic households buy are imported. Just consider where your clothes or electronics are manufactured. And you can see the same general pattern in Europe and the US. Many store chains and brands are the same, and they source from the same suppliers. Jay Powell, chair of the Fed in the US, said in a speech at Jackson Hole a few years ago that he was surprised about how sticky inflation was, also in a weakening economic environment. I think this is a good illustration of the importance of world trade and globalisation. This is a challenge for central banks, in that their traditional monetary policy tools can be quite ill suited for fighting the inflation they face, and can also be a poor match for domestic monetary conditions, such as inflated asset prices.

Historically, there has been a macroeconomic view of inflation being a speedometer for the economy. High inflation has been associated with higher economic growth and high resource utilisation, and vice versa. From this point of view, controlling inflation to a limited range of variability has been a way of seeking to stabilise the economy and the business cycle. But this perceived relationship between inflation and growth has not held up in recent years, leading to central banks of late instead overheating economies in their attempts to raise inflation to targeted levels. In Sweden, for example, I would argue this has been going on for the past 10 years. And this disconnect between monetary policy measures and macroeconomic outcomes has created major imbalances in economies which need to be resolved.

While there are not huge differences in how various OECD countries measure inflation, there are examples of major differences in inflation outcomes owing to differences in exposure to specific CPI components. In the Baltic countries, for example, energy prices largely doubled. Their unusually high energy price inflation has been a key driver of their even higher inflation spikes than in other OECD countries. In China, food is a slightly bigger component in the CPI basket than in western economies, which can drive Chinese inflation higher in times of sharply rising global food prices. But as a rule of thumb, CPI baskets are similar for western advanced economies.

JT: How is CPI linked to PPI or wage inflation? Which one matters the most for the economy? Are central banks and governments targeting the right metrics with their policies?

TI: A producer price index, or PPI, measures product prices at the factory gate. In small, open economies such as the Nordic countries, the link between PPI and CPI is quite weak. Just consider Sweden, where 80% of manufactured goods are exported. Some components of PPIs can be of interest for predicting or gauging inflation, such as food. And there are services PPIs, which happen to be among our best predictors for services inflation.

Central banks focus a lot on wage inflation, in their desire to avoid a potential pricewage spiral that could cement higher inflation. In this context, they watch services wage inflation particularly closely. What academic research generally shows is that inflation drives wage inflation, and not the other way around. Sure, there can be additional inflationary impulses if wages start to drift, but the core dynamic is that consumer prices rise and drive pressure on wages to rise to compensate. We expect wage inflation to generally increase in 2023, but service inflation to simultaneously ease from other drivers, such as falling demand and lower energy prices. But again, if we were to see sticky wage inflation in Europe and the US going forward, we will likely see much of the same in the Nordic countries.

My belief is that the historical link between CPI and wage inflation will largely remain. Despite big trend break events, such as Brexit and trade policy under the Trump presidency, there are few signs that the globalisation of trade is abating. We hear some companies saying they are starting to source more locally, and that they will not add new production capacity in China or Southeast Asia. This typically has to do with perceived political risks related to China, potentially leading to sanctions or other disruptions. Russia is seen as a clear example of what business risks could materialise. But at the same time, world trade volumes have grown sharply in the past two years. As an example, the imports share of Swedish GDP is currently at historical highs. To get a feel for it, have a quick think about where the Christmas presents you bought in 2022 were manufactured. So I am not quite prepared to declare an end for globalised trade. Companies are seeking to diversify their risks, but there have been and there remain strong economic drivers for sourcing globally, including from China.

JT: What are the best tools for controlling inflation? Monetary policy, fiscal policy or other tools? Are the tools central banks use today effective?

TI: I would argue that up until the COVID pandemic, central banks did not have sufficiently effective policy tools to manage inflation and bring it in line with their targets. Policy interest rates did not accomplish it, even when they became negative. And even unorthodox tools such as quantitative easing (central bank bond purchases) proved unable to hit the mark.

Theoretically, central banks could establish kiosks on street corners and distribute cash for free to passers-by. This would increase inflation, but is of course not a viable policy alternative. If you ask me, I would argue that even QE is not a reasonable monetary policy option – for a strong and generally well-functioning economy.

I think a better policy approach from central banks would have been to be somewhat more relaxed about inflation targets. Instead of going all in with policy rates and QE to really hit that 2% CPI level, they could let it fluctuate between perhaps 0% and 3-4%. There is research (see, for example, the Fed's September 2021 paper "Why Do We Think That Inflation Expectations Matter for Inflation? (And Should We?)" by Jeremy B. Rudd) showing that inflation varying within this sort of range is a non-issue for businesses and households. This could give room for central banks to be more pragmatic than dogmatic, prioritise economic growth and employment, and have room to focus more on important areas such as financial stability and home prices. I think Norges Bank, the Norwegian central bank, is a good example of this kind of approach. It has not done any QE, and it has not at any point lowered its policy rates to below zero.

A case can be made for QE or negative interest rates. But, to my mind, QE is a policy tool for extreme situations, to be used to manage a deep crisis. In short, it should be kept in the monetary policy toolbox for emergencies, while central banks would stand to gain a lot from being more relaxed and flexible in their pursuit of inflation targets. This would let them more effectively and helpfully weigh in on other key objectives and variables, including capacity utilisation, financial stability, home prices and the exchange rate. Not least as variables such as these can in the longer term have a major impact on inflation.

Fiscal policy, in my view, needs to be long-term orientated, and should aim to improve the functioning of the economy. It is inherently slow. It takes time for us to realise that actions are required. It takes time to decide on the measures. And it takes additional time until the measures have an effect. And by that point, the economy can be in a very different state from when the perceived need for fiscal policy measures arose. To give an example, the Swedish Riksbank held a seminar in December 2021, at which it was argued that an expansive fiscal policy was needed to help raise inflation to the targeted 2%. Given the subsequent global inflation spike, we should probably be grateful that the Swedish government did not heed that advice at the time. So, no, fiscal policy is not a great tool for controlling inflation. Central banks should stick to their monetary policy tools for reaching CPI targets, but with more humility and pragmatism.