TWO weeks ago the Jamaica Chamber of Commerce, as well as all of Jamaica's private sector associations that have spoken on the matter, shared that they were not in favour of further rises in interest rates.
As Jamaica's central bank also noted at the time, the debate over whether to tighten monetary policy is a global one, and it is certainly true that emerging market countries typically have much lower credibility than those of developed countries and therefore would be regarded as having less room for error regarding inflation.
Jamaica, however, had an unusually high level of very hard-earned credibility just before the pandemic shock. Interest rates were already near the nominal floor (so called lower bound) even before the pandemic, at half of one per cent, without triggering large portfolio shifts to US dollars — despite inflation averaging roughly 5 per cent over the last few years. This credibility has been maintained since the crisis and was recently recognised by rating agency Standard and Poors which moved our rating outlook from negative to a stable B+, reflecting its view that “the economic recovery will strengthen, government finances will return to a fiscal surplus this year, and the impact of the pandemic will gradually recede”. It even said that it could raise Jamaica's ratings over the next two years, depending on the strength of the economic recovery and its effect on government revenues, the fiscal balance, and the debt and interest burden.
The pre-pandemic cuts in interest rates had prompted some to concern about the dangers of running sharply negative real interest rates for a prolonged period of time. As expected, the most recent local inflation print of 8.2% for the twelve-month period up to September is substantially above our inflation target range, demonstrating why the Bank of Jamaica felt it needed to raise interest rates. On the other hand, the contrary argument was that the monetary transmission mechanism in Jamaica remained very poor — a fancy way of saying that a very low policy rate only passes through to businesses and consumers with a “long and variable lag”, the same phrase monetarist economists used to explain why their theories didn't work out in practice.
At a recent European Central Bank conference, London School of Economics Emeritus Professor Charles Goodhart (one of the world's foremost experts on monetary policy) made the remarkable statement that “the world at the moment is in a really rather extraordinary state because we have no general theory of inflation”.
Goodhart explained there used to be two competing theories of inflation: the Friedmanite monetary theory that inflation was the result of too much money chasing too few goods and the Philips Curve theory that postulated a relationship between inflation and unemployment.
Goodhart argues this has now been replaced with a “a bootstrap theory of inflation”, meaning that as long as inflation expectations remain anchored, inflation itself will remain anchored.
This, according to Goodhart, is “a very weak reed”, as inflation expectations are backward-looking and, unsurprisingly, people tend to extrapolate their recent experience into the future. To leave theory for a moment, this seems to accurately reflect the views of most business people. The global supply chain shock included a tripling of global freight costs, supply shortages and sharply higher costs of key goods, all combined with a volatile local currency, so it is not surprising that inflation expectations have risen.
All this suggests, at minimum, is that caution is in order in using inflation expectations as the basis to raise interest rates, and that we need a much more robust debate on the issue.
The debate continues globally, with former PIMCO chief economist Mohammed El Erian noting that inflation now looks “persistently transitory”, a phrase without meaning, reflecting his concerns global central banks could fall behind the curve in responding to inflation.
Today, we will leave the last word to the globally recognised international monetary and financial economist Professor Avinash Persaud, a Bajan national (and sometime co-author with Professor Goodhart) who has also presented his research locally in Jamaica mainly to the Bank of Jamaica. He observes :
“The essential point is that responding with an increase in interest rates to prices rising as a result of supply-side disruption by COVID is foolhardy. It is also potentially counterproductive and a rejection of the hard-earned lessons of the 1970s — the last time central bankers experienced rising prices due to supply-side disruptions. Interest rates are a demand-management tool. If there is too much consumer demand today and prices start rising as a result, increasing interest rates will help to push demand and prices back down. But suppose prices are rising because of a rise in international shipping costs, higher oil prices, or a global scarcity of manufactured goods? Higher local interest rates will not affect those things and will only result in higher unemployment and higher costs: stagflation. The point of the inflation target is that there is sufficient discretion for the central bank to respond differently if price rises as a result of unusual supply disruptions. To maintain its policy credibility, the central bank should develop some metrics that help it discern and signal whether it is dealing with international cost-push or local demand-pull inflation. One candidate would be the ratio of imported inflation to total inflation.”