Can Central Banks Control Inflation?
Under Paul Volcker, central banks acquired a reputation for being able to control inflation. But is this reputation deserved?
The story economists tell is the Volcker Fed raised interest rates to snuff out inflation. As a result of raising rates, unemployment skyrocketed and the economy slid into a recession. The decline in employment lead to a decline in wage increases. This in turn deprived inflation of the fuel it needed for additional inflation. So the conclusion for economists is central banks know how to end inflation by simply raising rates.
But what if this slick narrative is wrong?
I ask because shouldn’t central banks aggressively pursuing lower interest rates trigger inflation. If there is anything that we have learned since the beginning of the acute phase of the Great Financial Crisis in the EU/UK/US and since the early 1990s in Japan it is central banks aggressively pursuing low, even negative rates doesn’t trigger inflation.
My conclusion is the slick narrative about central banks misses a critical X factor in why the Volcker Fed was successful at ending inflation in the US and why central banks have been unable to trigger inflation more recently.
I think a very good case can be made the decline in inflation was as much a function of Ronald Reagan breaking the unions and the rise of maximizing shareholder value as it was Fed policy. Fed policy helped to undercut the unions’ ability to negotiate wage increases. At the same time, the idea of moving manufacturing overseas as a way to maximize shareholder value caught on. The result was the US imported the emerging market wage rates. Naturally, this is deflationary.
I think a good case can be made the reason central banks cannot trigger inflation is the existence of too much debt in the financial system. For example, this debt has given rise to corporate debt zombies who are unable to repay their debt. Due to regulatory forbearance at the bank level, these firms are allowed to continue operating (as oppose to pushed into bankruptcy and reorganized). As operating entities, they undermine the profitability and reinvestment opportunities of every industry they are in. This in turn undermines the ability of firms to increase wages.
Ultimately, central bankers don’t control the mechanism by which wages are set in the economy. While they might have some influence, it is a lot less than the narrative economists/central bankers suggests.