A political backlash against monetary policy is looming

Martin Sandbu in The FT

Three weeks ago, Sanna Marin, Finland’s prime minister, retweeted a link to an article by a Finnish academic together with the following quote: “There is something seriously wrong with the prevailing ideas of monetary policy when central banks protect their credibility by driving economies into recession.” 

Defenders of those prevailing ideas predictably pushed back, warning against second-guessing independent central banks or not valuing their credibility. But defensiveness is the wrong response. Not just because Marin didn’t actually criticise any central bank actions. But, more profoundly, because avoiding a debate over whether our macroeconomic regime is fit for purpose is more perilous than having one. 

Comparisons with the 1970s often fail to notice one important lesson of that decade: a macroeconomic regime that cannot justify itself will be toppled, first intellectually, then politically. It was from the ashes of 1970s monetary chaos that theories were born justifying independent central banks with a mandate to keep inflation low. Before the century was out, independent inflation-targeting was de rigueur in most advanced economies. 

Forty years on, a new intellectual and political reckoning would be less surprising than the absence of one. The “great moderation” produced by the 1980s monetary revolution has in many countries long been accompanied by stagnant wages for the low paid. The glacial recovery from the global financial crisis prompted the world’s two biggest central banks to revise their policy framework during the pandemic. In 2020 and 2021, the Federal Reserve and the European Central Bank vowed to tolerate a period of higher inflation if employment had further to rise or there would be little room to loosen policy in case of a downturn. But this new attitude fell at the first hurdle. 

With cost of living crises biting and recessions looming in key advanced economies, what are the odds of avoiding a more profound reckoning for much longer? Marin is not the only national leader expressing unease about central banks. French president Emmanuel Macron recently worried aloud about “experts and European monetary policymakers telling us we must crush European demand to contain inflation better”. 

Precisely because central bankers are independent, it falls to political leaders to tell their citizens why it is right to meet Russian energy blackmail with actions to clamp down further on incomes and jobs. They would be remiss if they did not question whether this is the best we can do. 

In comparison, central bankers have it easy. They have legally imposed inflation-fighting mandates, which are not for them to question. And they have an argument: that losing their “credibility” — by which they mean people no longer believe they can keep inflation low — will cost even more jobs and lost income. 

But the credibility of central banks itself is only as good as the credibility of the macroeconomic regime as a whole. That is not to say central bank independence should be jettisoned, but to ask openly whether it actually works for the economy. 

In pursuit of individual mandates central banks may be collectively overtightening, as Maurice Obstfeld has suggested. Or monetary policy uncoordinated with fiscal policy may be making matters worse, as Marin hinted in follow-up comments. 

The IMF has warned governments against budgeting “at cross-purposes” with monetary tightening. But raising interest rates puts monetary policy at cross-purposes with fiscal policy priorities such as investing in the green transition or, indeed, in energy infrastructure that would itself remedy energy-induced inflation. Even if monetary considerations should take priority, such monetary dominance is undoubtedly something to be democratically debated, not technocratically imposed. 

It may even be that central bankers are not independent enough but cave in to the political pressure arising from each new monthly record in current inflation, rather than coolly focusing on their benign medium-term forecasts. 

Like in the 1980s, in time bright economists will suggest better ways of designing monetary policy against energy price shocks. And unless we have a lucky escape from a sharp downturn this winter, a political backlash is surely coming too. The alternative to openly debating these issues in a democratic space is to let that backlash fester until it breaks out in the more radical and dangerous form of a populist assault on institutions. Central banks’ credibility would not be worth much then.