Persistently high inflation could erode the credibility of central banks while increasing inflation expectations, a key driver of inflation itself, the governor of the Central Bank of Ireland has said.
In an address to the London School of Economics, Gabriel Makhlouf also warned that the European Central Bank (ECB) had a long way to go before it gets inflation under control or back near its 2 per cent target rate.
“There is a risk that trust and credibility in central banks will take another buffeting from the recent high inflation,” he said.
“And, while headline inflation has declined from its end-2022 highs, in part thanks to lower energy prices, I believe we still have a way to go to return inflation sustainably to our 2 per cent target,” Mr Makhlouf said.
The ECB has increased interest rates five times since last July in a bid to control inflation, which has returned to levels not seen since the 1980s, a process that will continue next month, with policymakers expected to opt for another 0.5 per cent increase.
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Mr Makhlouf warned earlier this week that Frankfurt could raise rates above 3.5 per cent from the current 3 per cent level and would be unlikely to cut them again this year.
In his speech, the governor warned that central bank independence was “not just given; it has to be earned and maintained”.
“This means delivering on our price stability mandate in the first instance, and also communicating clearly the rationale for our policies,” he said. “Trust and credibility, painstakingly built over time, can be destroyed quickly.”
The governor told his audience that the lack of financial regulation had been identified as a key failing in Ireland’s financial crisis and it had been “a long road back for the Central Bank, in terms of rebuilding trust, requiring significant reforms”.
Mr Makhlouf said the case for independent central banks was as strong now as it ever was. “The price stability mandate ensures that central banks care more about taking the steps to tackle inflation than elected politicians might,” he said.
The governor warned that persistently high inflation eroded “economic capital”.
“If households, firms and financial markets no longer trust in the ability of the central bank to deliver its inflation target, we will see medium-term inflation expectations begin to drift above it,” he said. Economists have been warning that if inflation expectations become “de-anchored” and workers start demanding higher and higher wages, a wage-price spiral could develop.
Financial capital and investment was also put at risk “when borrowers’ resilience is threatened by rising prices and interest rates”, Mr Makhlouf said.
