We are too obsessed with monetary policy

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Ever come up against an unreliable shower tap? Turn slightly and it becomes too hot. Twist back and it takes ages to cool down. Well, that is the analogy Milton Friedman is said to have used to explain the difficulties of using the tools of monetary policy, which have “long and variable” lags, to target inflation.

But we seem to have forgotten Friedman’s warnings — that monetary policy is a blunt tool. First, the era of low inflation from the mid-1980s until the global financial crisis enhanced the credibility of central banks but perhaps also exaggerated their power. Second, after the crash, economies became more dependent on rate-setters given the only limited fiscal stimulus. Programmes and tools such as quantitative easing, yield curve control and forward guidance were introduced. This raised central banks’ influence on markets.

Today, central bank whispering is a full-time occupation. The regularity of committee meetings has fused with high-frequency trading, the 24-hour news cycle and social media. “Interest rates change daily, partly in anticipation of what central banks will do next. This transfers wealth across financial markets,” said Ricardo Reis, a professor at the London School of Economics. “It creates an obsession with monetary policy — even though the small daily moves in rates have a negligible impact on inflation.”

Inflation would indeed be higher today had central banks not raised rates. But this latest inflationary episode was driven by supply shocks, which interest rates cannot directly and rapidly remedy. Central bankers made mistakes early in this cycle, but the expectations on them were too high to begin with.

Monetary policy impacts demand in an imprecise manner. A change in bank rate or balance sheet operation influences financial market prices. That then has a knock-on impact on the cost of credit…