by NGOC ANH 11/09/2021, 11:27

Risk of policy mistakes from central banks

The risk of policy mistakes from government and central banks is high because of Covid-19. This is not just because nobody has lived through a global pandemic before; it is because it represents a supply shock, and these are very rare.

The Recruitment and Employment Confederation (REC) noted that starting salaries for permanent workers are rising at the fastest pace in the survey’s 24-year history, with starting salaries for temporary workers the second-highest on record. 

However, it is not just policymakers that will struggle, consumers and producers will struggle as well and that could lead to a more durable rise in inflation than policymakers and the markets expect.

In many countries, and notably the UK, employers are reporting that output is being constrained by difficulties in sourcing required materials and required workers. The Confederation of British Industry’s (CBI) most recent quarterly survey showed that these strains were the greatest since the 1970s when UK inflation peaked at over 25%. The Recruitment and Employment Confederation (REC) noted that starting salaries for permanent workers are rising at the fastest pace in the survey’s 24-year history, with starting salaries for temporary workers the second-highest on record. 

It is little wonder that Bank of England members, led by Governor Bailey said in testimony to parliament on Wednesday that they are becoming concerned about the wage situation. Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said that there would be plenty of reason to worry because firms, like the Bank of England, don’t quite know what is going on. Few could have experienced before the sort of worker shortage that is driving up wages. He suspects that many firms are panicking and lifting wages to try to entice workers in. But once the wage increases become embedded it will be hard to get them – and any resultant inflation – back down again. 

Things seem similar on the consumer spending side. Here too consumers are experiencing the sort of shortages of goods and services that only those living in the 1970s might remember. And while Brexit is clearly compounding the difficulty in the UK, because of the dearth of EU workers, other countries are seeing similar trends. For instance, Mr. Steve Barrow noted not too long ago that more people plan to buy used cars in the US over the next 6 months despite the fact that used car prices were up a staggering 54% in annual terms back in April and are still nearly 20% higher than year-ago levels today. As Fed Chair Powell put it, we are seeing a perfect storm when it comes to inflation right now as demand has surged and supply is lacking. 

It also seems that the response to price increases has become quite inelastic, as reflected in the fact that more people want to buy cars even though their price has soared in the US, or firms still want to hire many more workers in the UK even if the wages they are having to pay are increasing rapidly. This may simply be because virtually nobody has seen anything like this before. Shortages are meant to be things that are experienced in lesser developed countries, not advanced nations. Consumers and firms don’t know whether they will be temporary or long-lasting and seem to be acting as if they will be the latter. In the end that might well be the wrong choice. 

There are numerous reasons why product and labor supply will recover. But there are two problems. The first is that it might not bounce back to the same extent. For instance, those workers near retirement age that have opted to leave the workforce early because of Covid may never come back even if wages are higher. And the second is that the surge in prices and wages we are seeing could embed themselves in expectations for the future, making it very hard for policymakers to exert control. Hence, Mr. Steve Barrow thinks it is right that the Bank of England should be more concerned by wage trends, and price trends should be included on the watch-list as well. The Fed too, and indeed many other central banks, need to be aware of these dynamics. But, just as firms and consumers are flying blind when it comes to dealing with these issues, so too are the central banks and that elevates the risk of a policy mistake, particularly one where monetary policy is kept too accommodative for too long.