Sunday, 13 February 2011

Inflation and diplomacy - Axel Weber edition

Axel Weber, the current President of the Bundesbank, is resigning in May of this year. He also won't seek office as head of the ECB. There is a good deal of gloating in the press about him going. A well-known inflation 'hawk' and an opponent of the ECB's bond-buying extravaganza to keep Greece & Co. afloat, he is widely considered not diplomatic enough for leading the ECB. For example, his open dissent about the bond purchases last year is seen as an unacceptable lack of esprit de corps.

To be honest, the whole logic of this line of reasoning is passing me by. Central bankers are not diplomats. At some point, Western countries decided that independent, technocratic institutions are better at making monetary policy than politicians. The Fed under Volcker, and the Bundesbank under Hans-Otto Pöhl, are excellent examples of how to do this right. Was there anything diplomatic about raising interest rates in the middle of a recession, as both of them did in the early 1980s? For sure not. They courted controversy, told smooth-talking politicians begging for some easy money to take a hike, and helped to bring inflation (and inflationary expectations) under control. In the long-run, there is no tradeoff between inflation and unemployment; only dead inflation is good inflation.

When the ECB was set up, it was meant to inherit the inflation-fighting prowess of the Bundesbank. One shouldn't exaggerate the implications of a single personnel decision, but I see a broader pattern that is turning the ECB into more of a mixture between the Bundesbank of old and, say, the bad old Bank of Italy or Banco de Espana, which presided over double-digit inflation for decades. Where Pöhl and friends would hike interest rates overnight by a few hundred basis points, with no warning, cold-turkey style (even the early Greenspan pulled one of these off), the new regime hopes to guide expectations through the most esoteric of shifts in bureaucratese, thinking that if they say "strong vigilance" against inflation instead of "vigilance", bond markets and the economy at large will get it. Interest rates? Almost never shall they be touched, and if so, by 25 basis points every 6 months, maybe.

So far, the inheritance of strong inflation-fighting credentials from the past, plus a benign macro environment, have ensured that this sort of magic worked surprisingly well. But at some point, I fear that stronger medicine will be needed - someone, at some point, will have to do the ugly thing of raising interest rates, big-time, perhaps even if growth is not looking pretty, because inflation is too high. Who are you going to call? Suave, smiling diplomats, who got their jobs by being nice to their home country politicians, or by working for Goldman Sachs? Or blunt, robust characters with solid academic qualifications, like Axel Weber? For my money, the fact that he was a bit rough around the edges, said what he thought, didn't take his views from the editorial pages of the FT, and wasn't afraid to p*** off some politicos, was the strongest set of recommendations anyone could have for the top job. Shame that it's not the kind of person who will lead the ECB.

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