Postmodern central banking

The Bank of England says it's raised interest rates to reduce inflation. This runs into an obvious objection. This classic paper (pdf) by Chris Sims showed that higher interest rates lead to higher inflation.
Well, it's taken 15 years, but Bank economists have found a good reply to this so-called price puzzle. This paper (pdf) estimates that the puzzle only exists where central banks don't much raise interest rates in response to higher inflation - for example, in the US before 1979 or in the UK before inflation targeting began in 1992.
This is because of the importance of inflation expectations. When central banks are weak, people regard a rise in interest rates as a sign of even more inflation to come. They figure: "Hey, inflation must be a problem if the weedy central bank is prepared to raise interest rates. I'd better put up my prices (or demand a pay rise) in anticipation of  higher inflation." The upshot is that higher interest rates do indeed lead to higher inflation.
However, when the central bank is more determined to fight inflation, expectations are different. People think: "if the Bank's determined to raise interest rates, I can't afford to risk losing demand by raising prices (or wages)." The upshot is that inflation falls and the price puzzle no longer exists.
But how does a central bank ensure that inflation expectations are "right"? It can only do so by raising rates aggressively, to show its anti-inflationary credentials.
In this sense, higher rates are necessary not to control inflation directly, but to control expectations; the impact on inflation operates via these.
It's post-modern central banking; the message is all.

Comments

[james higham]

When did it happen? In Australia, they just went up by 0.25% and I wrote of it today. Will they rise further?

[Shuggy]

The perception becoming reality. But what's 'post-modern' about this, Chris? Isn't this the same principle that lies behind runs on banks and currencies?

[dsquared]

Regrettably, it is probably indeed "post modern" for economists to admit that there is a symbolic role to their behaviour. I think, though, that what the Sims paper actually shows is that time series analysis is very difficult.

[snowflake5]

The "surprise" element helps too. So much of central banking is devoted to managing the expectations of the financial markets that not enough thought is given to the value of the surprise or shock. I can't help feeling that inflation has got a hold in the USA because Greenspan and now Bernanke have paid too much attention to not shocking anyone, and everyone has got cosy and comfortable and assumed that of course the bank will put growth ahead of inflation.

Good on the BoE for reminding people what they are about (people here too have become cosy and comfortable these last few years).

[ChrisA]

I guess I am still confused as to why the market does not set interest rates instead of the central bank. For instance, even in the case that there is a weak central bank surely private lenders of money should react to the perceived risk of inflation by raising the interest rate they require to lend money. This should then should choke off demand and reduce inflation - if the thesis is correct that higher central bank interests rates reduce inflation (by reducing demand). Of course the carry trade (borrow short term money from the central bank and lend long term to others) would still exist for certain players which would could keep market rates artificially low for a time - but even weak central banks can be expected to raise rates eventually to near market thus exposing the carry trade. My belief is that this is a supply of money problem rather than interest rates. The low inflation we have seen in recent years is really a reflection of reduction in money supply - basically less proflicacy by central governments. To be really really post modern therefore I would say that adoption by governments of an independent central bank with inflation targeting is a signal to the markets of a desire by said govt to act sensibly in matters of monetary policy and not inflate the money supply thus lowering inflation expectations thus lowering interest rates.

[james higham]

Be very careful of Independent Central Banks - India is going this route and remember what happened in the US with the cartel which runs the show over there.

[james higham]

By the way:

"The Bank of England says it's raised interest rates to reduce inflation. This runs into an obvious objection. This classic paper (pdf) by Chris Sims showed that higher interest rates lead to higher inflation."

So which one do you believe?