How should central banks respond to increased uncertainty? This is the question facing the Fed, ECB and Bank of England as they prepare for next month’s meetings.
Russia’s invasion of Ukraine has increased uncertainty. In forcing up oil and gas prices, it will push inflation even higher in the near term, exacerbating the danger that high inflation might feed on itself by leading to higher inflation expectations and pay rises. But, on the other hand, those same higher prices will cut our real incomes: if we must pay a fortune to fill up our cars and heat our homes, we’ve little left to spend in shops. That will hold prices down. The task of weighing these competing pressures has become tougher – all the more so because oil prices will depend upon the course the war takes, and nobody can predict this.
There’s a strong theory for what central bankers should do about this. Back in 1967 William Brainard showed that in times of uncertainty they should do less than they usually would. This principle, says Princeton University’s Alan Blinder was “never far from my mind” when he was Vice-Chair of the Federal Reserve. And it seems like common sense: don’t meddle in what you don’t understand.
Certainly, many companies behave like this. Stanford University’s Nick Bloom has showed that they tend to invest less when uncertainty increases. This is because a planned investment project is an option: you have the choice of undertaking it or not. And just as financial options become more valuable when uncertainty increases, so too do real options. And the more valuable an option is, the more you should hold it rather than exercise it.
Central bankers should therefore be wary of raising interest rates.
But. The social sciences are not like the natural sciences: there are few general principles. Instead, context is everything. As Andrew Caplin and John Leahy have shown, sometimes central banks must instead act very aggressively: Brainard conservatism, for example, was entirely the wrong response to the 2008 financial crisis.
So, are in a Brainard world or a Caplin-Leahy world? One reason to think the latter is that there’s a difference between a central bank thinking of raising rates and a company thinking of investing. Many investments are irreversible: once contracts with suppliers are signed, you are on the hook. It’s natural to be cautious about such investments at a time of uncertainty. Rate rises, however, are reversible: if they prove to be mistaken central banks can do a U-turn. This argues for ignoring Putin-induced uncertainty and – in the case of the Fed and Bank of England at least – raising rates.
But (again!). Reversing rate rises is costly, and not just because it makes central bankers look foolish. If markets come to think that changes in rates will be reversed, longer-term interests won’t change when short-term ones do, because higher short-term rates won’t much change expectations of future rates. That will weaken the impact of future monetary policy changes. If monetary policy is to remain powerful, central bankers must therefore avoid policy reversals – which means acting cautiously.
Also, rate rises only cut inflation by inflicting real harm: higher mortgage rates mean lower real incomes, and a higher cost of capital (at the margin) deters companies from hiring and encourages them to cut jobs. At a time when higher oil prices are doing this same damage, central bankers must tread carefully. So yes, Brainard conservatism is still relevant.
