Never mind inflation – central banks must see the bigger picture

The focus on inflation is flawed – we would all be better-served by prioritising growth

Sooner of later, interest rates will rise. I haven’t been able to find a forecaster who thinks that will happen in Europe in 2018 but it is certain as these things can be that we will see two or more rate rises in the United States and the UK this year. Probably even more in the case of the US.

The European economy is booming. The European Central Bank looks ever harder for signs of accompanying inflation but is evidently astonished that it can’t find any. So much so that it points us to a new(ish) concept – “supercore” inflation: a measure of price rises that seems to strip out everything that isn’t actually going up.

According to some ECB watchers that could mean ignoring as much as 60 per cent of prices. That’s quite a lot of stripping. Cynics point out that you will always find some price rises if you look hard enough. Central banks are supposed to look at the bigger picture. But what does that look like?

Alongside the economy, the euro is also on something of a tear, at least against the dollar. A good start to the year for the single currency was capped last week by the announcement a preliminary agreement for a new coalition government in Germany. Markets like political stability.


Angela Merkel’s successful laying of the groundwork for a new coalition also helped underpin sterling. The value of the UK currency is the best single barometer of Brexit’s prospects: the absence of a German government would have made a deal (of any kind) quite hard to achieve. The Germans can now, it is assumed, take their place at the Brexit negotiating table undistracted by domestic political turmoil.

Brexit compromises

Sterling has also been helped by the strange disappearance of the hard Brexiteers. Lots of suggestions about various potential Brexit compromises have emerged in recent days with scarcely a peep of protest from the usual suspects.

Some analysts think that the Johnsons and Goves of this world have been battered into submission by a cold dose of reality. Whispers of the softest Brexit possible – leave the EU in name only with absolutely everything else staying the same – have been greeted with an eerie lack of the usual cries of betrayal.

Nigel Farage, as ever, captured it all beautifully. Farage, the only uber-Brexiteer to pop his head above the parapet in recent days, suggested that a second referendum should now be considered. And then, within hours, he denied he said any such thing. This is how modern politics is played: say something outrageous and then deny it. All straight out of the Donald Trump playbook.

The heads of woolly liberal commentators heads explode on cue, utterly failing to see how Farage and Trump’s base quietly applaud the original comment and laugh at the outrage deliberately caused. It’s called capturing the agenda. If there is a second referendum or, more likely, a general election, the Brexiteers will undoubtedly claim that the only way to save the NHS from total collapse will be to leave the EU.

See how quickly the debate over interest and exchange rates switches from economics to politics? European interest rates may well rise sooner than expected but the issues are no longer just about growth and inflation (supercore or otherwise). More than anything else, the resumption of robust economic growth has, for now, stemmed the tide of European populism.

Income distribution

Brexit and Trump are political phenomena with deep economic roots. Lack of economic growth, particularly for the bottom half of the income distribution, accounts for a lot of the rise of populism.

Growth cures a lot of ills, not just unemployment. In a book published just as the financial crisis was beginning to unfold, Harvard professor Ben Friedman expounds on his title, The Moral Consequences of Economic Growth. Nobel prize winner Robert Solow reviewed the book, saying "Friedman argues calmly, thoroughly and convincingly that rising incomes create an environment favourable to democracy, tolerance and solidarity, while stagnation does the reverse".

Stagnation makes inequality worse and assists the rise of politicians such as Nigel Farage. It’s not exclusively about growth, of course: the main reason why Ireland didn’t adopt pitchfork politics like the UK and US is because of aggressive income redistribution through the tax and welfare system. But growth is the thing that gives us jobs and the resources needed for public infrastructure and that redistribution.

When thinking about interest rates, I wonder how much this enters into the deliberations of central bankers. This is the bigger picture that I worry they don’t pay nearly enough attention to. In searching for the inflation bogeyman they are, perhaps as always, fighting the last war. The next financial crisis may have political rather than economic roots.

Central banks are there to fight financial instability as much as they have to ward off inflation. Politically and financially, it might be a good time to allow economies to grow, even if that means flirting with inflation. Most of us might hope for a soft Brexit but we all need Mario Draghi to keep the recovery going.