Inflation and its effect on central bank’s independence

Given inflation and growth trends, Fed officials signaled clearly that they would speed up the end of the central bank’s bond-buying program and was likely to raise interest rates sooner than had been envisioned.

Inflation and its effect on central bank's independence

By Srishti Sahu

The Federal Reserve is rolling out a new plan to fight the high inflation rate. The annual inflation rate in the US accelerated to 6.8% in November of 2021, the highest since June of 1982. At this point, most economists believe that inflation is transitory until proven permanent.

If this inflation proves out to be only transitory, any stringent monetary policy like sharply raising short term interest rates or quickly unwinding those government asset purchases (called Quantitative Easing or QE), which was highly effective during COVID-19 shock, will slow down the recovery.

Also Read: WPI inflation at a record high and its implications

Given inflation and growth trends, Fed officials signalled clearly that they would speed up the end of the central bank’s bond-buying program and was likely to raise interest rates sooner than had been envisioned. Economists think that officials will signal a plan to taper off bond purchases so that the buying will stop altogether in March.

Federal Reserve Chairman, Jerome Powell had previously said that this bout of inflation is transitory. But during his recent speech, the Fed seems to be backing off from using that language. In his congressional testimony last week, Mr. Powell affirmed,

“I think that the data we got toward the end of the fall was a really strong signal that inflation is more persistent and higher, and that the risk of it remaining higher for longer has grown,” he said in the news conference. “And I think we are reacting to that now.”

Causes of inflation

As you can see below, the recent surge in prices is not large compared with those of the 1970s and early 1980s, which were caused by large increases in oil prices.

Inflation and its effect on central bank's independence

Consumer price inflation in some economies, 1970-2021

However, if one compares the current inflation increase to the 2000s, it is one of the biggest shocks since the Bank of England became independent and the ECB was set up.

Consumer price inflation in the UK, US and Eurozone, 2000-21

Inflation and its effect on central bank's independenceMaintaining stable prices is one of Central Banks main responsibilities. Today’s inflation is primarily due to the disruption in the global supply chain as a result of pandemics. Businesses that had reduced their inventories and lowered their breakeven costs during the pandemic are restocking to meet resurgent demand. Bottlenecks and shortages in key inputs of vehicle and electronics production, such as semiconductors emerged as consumer demand recovered more rapidly after the first pandemic wave than suppliers could keep up with. Similarly, shortages of shipping containers and freight capacity have increased costs.

The rapid economic recovery in 2021 has also put pressure on energy prices, especially spot gas prices in Europe.


Economists believe that expectation is the primary driver of inflation. If people think that inflation will remain high for a longer time, they would demand higher wage raises. And for the employers, higher long-term inflation would mean incorporating it in setting future prices of the product. This will eventually make inflation more persistent.

A wage rise would mean a corresponding increase in prices unless productivity is increased proportionately. A similar situation that occurred in the 1970s, that sent the economy into a wage-price spiral, is different from today’s situation where the labour markets are more flexible. This means that trade unions have less wage-bargaining power in the private sector, and there is greater international competition as a result of globalisation. Rather than setting off a wage-price spiral, rising prices might therefore be absorbed by wages falling in real terms (meaning they would increase below the rate of inflation).

Labour market

Central Banks ability to manage inflation depends upon the extent to which the inflation is driven by the labour market.

Labour force participation has been falling in the US and UK as a result of people retiring. Tens of millions of Americans lost their jobs (or left them voluntarily) during the Covid recession, which resulted in a lot less stuff being produced. American bank accounts were buttressed with expanded unemployment insurance and direct stimulus, but those dollars were ultimately chasing fewer goods and services since fewer people were working.

Businesses, meanwhile, have had a difficult time throughout 2021 hiring enough workers to satisfy demand, and the labour-force participation rate is 1.7 percentage points lower than before the pandemic.

The central bank and its independence

The key to gauging whether inflation remains transitory will be the future labour market and expectations data. Suppose that by early to mid-2022, inflation appears to be dissipating, central banks might only need to increase rates gradually to anchor expectations.

But if the data points to inflation remaining stubbornly higher than central banks’ inflation targets (say 4%-5%) for a longer time horizon, it would be evidence that a wage-price spiral has set in. Central banks would then have no alternative but to substantially increase short-term interest rates and reduce QE – potentially reducing economic activity until wage and price increases moderated. As we know from the 1970s and early 1980s, this can cause painful recessions, leading to unemployment.

At any rate, QE needs to be ended carefully. It has created extra demand for government bonds and increased the supply of money available to invest in other assets such as stocks, so tapering has the potential to cause volatility in these markets. This is likely to be compounded by investors selling stocks in the belief that tighter monetary conditions will mean less economic growth.

The QE purchases have also greatly enlarged central banks’ balance sheets. For example, the Fed balance sheet has increased from around US$4 trillion (£3 trillion) to US$8.7 trillion since the start of the pandemic. Besides tapering, this is going to have to be unwound. It can either be done very slowly as QE-debt matures or – if central banks feel they need to tighten monetary policy more aggressively – by selling these bonds onto the market. This might mean selling at a loss, in which case governments would have to rebuild central banks’ balance sheets. By making central banks dependent on governments in this way, it might compromise their independence.

There is also a more immediate challenge to central-bank independence, which was granted several decades ago to stop the monetary policy from being subject to political interference and to reassure the markets that inflation would be kept under control. Yet just because a central bank sets rates independently of government, it may not be immune from external pressures during a major economic crisis. Central bankers could succumb to political and media pressure either to move too fast on tackling inflation or too slowly to preserve the economic recovery.

Some central banks like the Bank of England look set to hold fire on interest rates until early 2022 – despite the comments from Huw Pill – given the uncertainties surrounding the omicron variant. The ECB is similarly holding steady. So all eyes will be on the Fed on Wednesday 15 to see if it is going to taper QE faster than previously announced. For the time being, I would argue that it would be better to wait. The next few weeks will give us more data on both inflation expectations, but also on how COVID might continue to affect our economies.

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Inflation and its effect on central bank's independence
Given inflation and growth trends, Fed officials signaled clearly that they would speed up the end of the central bank’s bond-buying program and was likely to raise interest rates sooner than had been envisioned.
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