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The absurdity of controlling inflation by adjusting interest rates

The idea that a central bank can control inflation by adjusting interest rates is shown by the evidence to be absurd.

It is yet another example of the limits to knowledge in orthodox macro-economics.  

Mark Carney, Governor of the Bank of England, is getting his retaliation in early.  Faced yet again with the Bank failing to deliver its designated target of a 2 per cent inflation rate, in a speech last week he suggested that his remit was broader.

“We face a trade-off between having inflation above target and the need to support, or the desirability of supporting, jobs and activity”, the Governor stated. 

In other words, he claimed that the Monetary Policy Committee (MPC) of the Bank should be concerned not just with inflation, but with what economists describe as the “real” economy, output and jobs.

The Federal Reserve in the United States is explicitly mandated to take account both inflation and the real economy when it sets interest rates.  This is definitely not the case with the Bank of England.  When Gordon Brown made it independent in 1997, its remit was unequivocal.  It was to ensure that inflation was 2 per cent a year.

This time round inflation is above the Bank’s target.  The current level of some 3 per cent may even rise in the short-term because the weakness of sterling is pushing up the cost of imports. 

But in recent years, inflation has been below the 2 per cent desired rate, even falling to zero in 2015.

And all this time, Bank rate has been essentially flat.  The MPC cut it to just 0.5 per cent in March 2009, where it remained until the reduction to 0.25 per cent in August 2016.

To put this into perspective, when the rate fell to 1.5 per cent in January 2009, this was the first time it had been below 2 per cent since the Bank was created in 1694, well over 300 years ago.

So here is a puzzle for mainstream macroeconomists, whether in central banks or universities.  Central banks are meant in theory to be able to control inflation by setting short-term interest rates.  Inflation has been low since 2009.  But at the same time Bank rate has been at all-time record lows.

Perhaps more pertinently, inflation has fluctuated from year to year, even though interest rates have to all intents and purposes not changed.  It was 4.5 per cent in 2011, and 0.7 per cent in 2016.

In short, inflation seems to lead a life of its own, independently of what the experts on the MPC either say or do.

Inflation really is a naughty boy all round.  A central concept in orthodox economic thinking, encapsulated in the quote from Mark Carney above, is that there is a trade-off between inflation and jobs and output.  The faster the economy grows and unemployment falls, the higher will be inflation.

But starting in the early 1990s, for around 15 years across the entire Western world both inflation and unemployment experienced prolonged falls.

The idea that a central bank can control inflation by adjusting interest rates is shown by the evidence to be absurd.  It is yet another example of the limits to knowledge in orthodox macro-economics.  

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