This article originally appeared in the Financial Post.
By Philip Cross, July 6, 2022
The run-up in inflation over the past year surprised central banks and consistently outstripped economists’ forecasts. In Canada, the consensus forecast of a 7.3 per cent increase in the May CPI was well below the 7.7 per cent result. The Bank of Canada promises a preliminary study soon of the costly “inflation forecast errors” that Deputy Governor Paul Beaudry recently acknowledged.
While we’re awaiting its results, I think it’s safe to say the reasons for central banks’ misjudgement of the recent surge in prices include: the ascension of academic over practical knowledge of the economy, the cult of celebrity central bankers and a growing trend to “groupthink” in central banks, especially in de-emphasizing the money supply’s role in the economy.
These days academic economists dominate central bank staffs. This was not always the case. No economist led the U.S. 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 of Governors immediately after World War II. With his background in investment banking, current Fed Chair Jerome Powell marks a return to that tradition.
Economists’ domination of central banks is suffocating. One former Fed governor told Fed historian Peter Conti-Brown that “Without a PhD in economics, the Fed’s staff will run technical rings around you.” Powell admits that being surrounded by hundreds of PhD economists is intimidating, complaining that “they talk to me like I’m a golden retriever.”
The lack of a practical understanding of the economy was revealed during the 2008 financial crisis. Monetary expert Barry Eichengreen noted the Fed’s model of the economy did not incorporate financial innovations like collateralized debt obligations since “Fed staffers were more likely to have graduated from university departments of economics than investment bank trading floors. Only a handful had even heard of collateralized debt obligations.” Claudio Borio of the Bank for International Settlements has noted, more generally, that macroeconomic models typically neglect financial cycles, which he says is like “Hamlet without the Prince of Denmark.”
Inflation’s recent surge shows that ignorance about how the economy works extends to the supply side and not just the financial sector. The Hoover Institution’s John Cochrane recently criticized the Fed for not really understanding supply and, for instance, relying 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 the ports.” The Fed used to possess such knowledge. Former Chair Alan Greenspan was legendary for his grasp of the inner workings of the economy. When a bridge over the Mississippi washed out, he knew exactly how this affected transportation in the area. But central banks no longer seem to prize such nuts-and-bolts knowledge.
A related problem is “groupthink” among the economists controlling central banks. Jonathan Ferro of Bloomberg Surveillance recently compared Fed groupthink with the considerable diversity of opinions circulating in European central banks. The Bank of Canada seems even more susceptible to the problem — partly for structural reasons. Hearing different voices is easier in Europe, with its many national central banks, and at the U.S. Fed, which has representation from each of the 12 separate Federal Reserve Districts into which the Fed divides the U.S. The Bank of England reserves four of the nine seats on its Monetary Policy Committee for outsiders. Three of the four supplied all of the dissenting votes to its recent timid interest rate increase, recommending a larger hike. By comparison, the Bank of Canada lacks an institutional mechanism that brings diverse views into its decision-making.
Groupthink and isolation are compounded by the cult of celebrity surrounding central bankers. Greenspan was the first to reach “rock-star status,” in the words of Ben Bernanke. When President Bill Clinton was asked about being the world’s most powerful person, he pointed to Greenspan’s wife and said “Ask her. She’s married to him.” Today’s central banking world has no bigger rock star than former Bank of Canada/Bank of England Governor Mark Carney. Perhaps in reaction to his excesses, Carney’s successors have been lower-key, partly inoculating the Bank of Canada against the worst effects of central bank celebrity.
One reason for groupthink in central banks is their emphasis on specialized knowledge. But the payoff from this specialization is often hard to see. Ben Bernanke was expert in the monetary origins of the Great Depression, yet he missed the onset of the Great Financial Crisis. Janet Yellen was renowned for her work in labour markets but was mystified by the flattening of the Phillips Curve relationship between unemployment and inflation. Greenspan’s veneration of markets blinded him to the build-up of a massive housing market bubble.
All these themes come together in how central banks de-emphasized monetary aggregates in recent decades. The strict monetarism of the 1970s and early 1980s, which maintained that the money supply alone determined economic growth, led to a preference for rules-based over discretionary monetary policy. Since then a gradual return to discretionary judgement exercised by groupthink leaders and celebrity central bankers has intimidated critics. Central bankers’ recent bungling of inflation demonstrates these financial emperors have no clothes, a lesson learned that will be good for the rest of us in the long run.
Philip Cross is a Munk Senior Fellow at the Macdonald-Laurier Institute. Prior to joining MLI, Mr. Cross spent 36 years at Statistics Canada specializing in macroeconomics.