The future perspective on current monetary policy

 

Ever since the Fed and the ECB have embarked on their journey of rapid tightening, there was a heated debate about the appropriateness of this policy. Ultimately, this question rests on the persistence of current inflation, which pits against each other the by-now-infamous team transitory against their opponents of team persistent. At this point it is fair to say that we really don’t know which side was correct, or maybe more precisely, which side was more correct, as neither of the extreme perspectives were likely correct. But what about in future, will we know? I don’t think so. I think both sides will claim forever that they were correct, and ultimately, the actions of the central banks will prove both of them correct.

What do I mean? Imagine that in a 1-2 years  from now inflation is back to around target. What does that mean for team transitory and team persistent? Team transitory will be able to point out to inflation back to target and say “See, the inflation spike was after all not persistent, given that we went back to target. Of course, the team persistent will say that the only reason why inflation went back to target was because of the action by central banks, which broke down the persistent inflation, and that without such action the inflation would be persistent. And as for central banks themselves, clearly, if inflation comes back to target, they will feel vindicated, claiming that their policy was correct all along. Hence, inflation going back to target settles nothing.

Arguably, if inflation only goes back to 2% and not below, I would conclude that team transitory was not correct: the rapid tightening clearly will have impact  on inflation rate, and hence if even with it we do not undershoot, then in absence of it we would have overshot the target.

Now imagine that in 1-2 years from now, inflation is actually well below target, likely in combination with recession between now and then. Does this change the debate? Does it vindicate team transitory? I don’t think that team persistent will accept defeat in this situation. They will claim that the inflation was persistent, and that central bank had no choice but to tighten rapidly, even if it meant recession and below-target inflation rate. They will point out that in absence of such action the sky-high inflation rate would lead to de-anchoring of expectations and inflation persistently above target. In other words, the argument was that breaking down the high inflation and landing exactly on target simply was not in cards.

Arguably, in such situation I would conclude that team persistent was not correct: while I can see a case to be made about inflation expectations de-anchoring, like this kind of Jedi Mind Economics is not really persuasive for me: we have very little understanding of how expectations get formed, what can cause inflation expectations to de-anchor, and whether that would actually meaningfully influence inflation. So if the argument rests solely on theocratizing about evolution of inflation expectations, count me out. (I am not saying that inflation expectations are irrelevant, just that given our current empirical understanding, I would not make them central to my explanations of empirics).

Only if inflation even after 2 years is still clearly above target is there a chance that the discussion will be concluded. It will be hard for team transitory to argue that 4 years of high inflation is really a transitory phenomenon. That is, unless there is further shock along the way, but again, that to me will start to feel tenuous.