Rising inflation over the past year surprised central banks and consistently outperformed economists’ forecasts. In Canada, the consensus forecast of a 7.3 percent increase in May’s CPI was well below the 7.7 percent result. The Bank of Canada is soon promising a preliminary study of the costly “flaws in the inflation forecast” recently acknowledged by Vice Governor Paul Beaudry. While we wait for the results, I think it’s safe to say that the reasons for central banks’ misjudgment of the recent price hikes are: the rise of academic working knowledge of economics, the cult of famous central bankers and a growing trend of ‘groupthink’ in central banks, especially in a lesser emphasis on the role of money supply in the economy.
Today, academic economists dominate the central bank staff. This was not always the case. No economist ran the US Federal Reserve Board before 1970. Central banking was seen as an extension of banking, not economics, and there were no economists on the Fed’s board immediately after World War II. With his background in investment banking, current Fed Chair Jerome Powell marks a return to that tradition.
The dominance of central banks by economists is stifling. A former Fed governor told Fed historian Peter Conti-Brown that “Without a PhD in economics, the Fed staff will run tech rings around you.” Powell admits it’s intimidating to be surrounded by hundreds of PhD economists and complains that “they talk to me like I’m a golden retriever.”
The lack of a practical understanding of the economy came to light during the 2008 financial crisis. Monetary expert Barry Eichengreen noted that the Fed’s model of the economy did not include financial innovations, such as collateralised debt obligations, as “Fed executives graduated from university economics departments rather than investment bank trading floors. Only a handful had even heard of collateralised debt obligations.” More broadly, Claudio Borio of the Bank for International Settlements has noted that macroeconomic models tend to ignore financial cycles, which he says is like “Hamlet without the Prince of Denmark”.
The recent rise in inflation shows that ignorance about how the economy works extends to the supply side and not just to the financial sector. John Cochrane of the Hoover Institution recently criticized the Fed for not really understanding the offer, relying, for example, on the unemployment rate as an indicator of economic slack: “There are no groups of analysts at the Fed measuring how many containers can get through ports.” The Fed used to have such knowledge. Former chairman Alan Greenspan was legendary for his insight into how the economy works. When a bridge washed away over the Mississippi, he knew exactly how it affected transportation in the area. But central banks seem to have such knowledge. no longer appreciated.
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A related problem is “groupthink” among the economists who control central banks. Jonathan Ferro of Bloomberg Surveillance recently compared Fed groupthink to the wide variety of opinions circulating among European central banks. The Bank of Canada seems even more sensitive to the problem, partly for structural reasons. It’s easier to hear different voices in Europe, with its many national central banks, and with the US Fed, which has representation from each of the 12 separate Federal Reserve districts into which the Fed divides the US. The Bank of England reserves four of the nine seats on its Monetary Policy Committee for Outsiders. Three out of four all voted against the recent timid rate hike and recommended a bigger hike. By comparison, the Bank of Canada lacks an institutional mechanism that brings divergent points of view into its decision-making.
Groupthink and isolation are exacerbated by the celebrity cult surrounding central bankers. Greenspan was the first to achieve rock star status, in the words of Ben Bernanke. When President Bill Clinton was asked if he was the most powerful person in the world, he pointed to Greenspan’s wife and said, “Ask her. She married him.” Today’s central banking world has no bigger rock star than former Bank of Canada/Bank of England governor Mark Carney. Perhaps in response to his excesses, Carney’s successors were less important and they gave the Bank or partially vaccinate Canada against the worst effects of central bank celebrity.
One reason for groupthink at central banks is their emphasis on specialized knowledge. But the payoff of this specialization is often hard to see. Ben Bernanke was an expert on the monetary origins of the Great Depression, but he missed the start of the Great Financial Crisis. Janet Yellen was known for her work in the labor market, but was baffled by the flattening of the Phillips curve relationship between unemployment and inflation. Greenspan’s veneration of markets blinded him to the creation of a huge housing bubble.
All of these themes converge in the way central banks have emphasized monetary aggregates in recent decades. The strict monetarism of the 1970s and early 1980s, which held that only the money supply determined economic growth, led to a preference for rules-based over discretionary monetary policy. Since then, a gradual return to discretionary judgment by groupthink leaders and famous central bankers has intimidated critics. The recent tampering with inflation by the central bankers shows that these financial emperors have no clothes on, a lesson we have learned that will be good for the rest of us in the long run.
Philip Cross is a senior fellow at the Macdonald-Laurier Institute.