Philip Cross: Why central banks screwed up 

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The run-up in inflation over the past year surprised central banks and consistently outstripped economists’ forecasts. In Canada, the consensus forecast of a 7.3 per cent increase in the May CPI was well below the 7.7 per cent result. The Bank of Canada promises a preliminary study soon of the costly «inflation forecast errors» that Deputy Governor Paul Beaudry recently acknowledged. These days academic economists dominate central bank staffs.

Central banking was seen as an extension of banking, not economics, and there were no economists on the Fed’s Board of Governors immediately after World War II. Economists’ domination of central banks is suffocating. One former Fed governor told Fed historian Peter Conti-Brown that «Without a PhD in economics, the Fed’s staff will run technical rings around you.» Powell admits that being surrounded by hundreds of PhD economists is intimidating, complaining that «they talk to me like I’m a golden retriever». The lack of a practical understanding of the economy was revealed during the 2008 financial crisis.

Monetary expert Barry Eichengreen noted the Fed’s model of the economy did not incorporate financial innovations like collateralized debt obligations since «Fed staffers were more likely to have graduated from university departments of economics than investment bank trading floors. Only a handful had even heard of collateralized debt obligations.» Claudio Borio of the Bank for International Settlements has noted, more generally, that macroeconomic models typically neglect financial cycles, which he says is like «Hamlet without the Prince of Denmark». Inflation’s recent surge shows that ignorance about how the economy works extends to the supply side and not just the financial sector. A related problem is «groupthink» among the economists controlling central banks.

Jonathan Ferro of Bloomberg Surveillance recently compared Fed groupthink with the considerable diversity of opinions circulating in European central banks. Hearing different voices is easier in Europe, with its many national central banks, and at the U. By comparison, the Bank of Canada lacks an institutional mechanism that brings diverse views into its decision-making. Groupthink and isolation are compounded by the cult of celebrity surrounding central bankers. Perhaps in reaction to his excesses, Carney’s successors have been lower-key, partly inoculating the Bank of Canada against the worst effects of central bank celebrity.

One reason for groupthink in central banks is their emphasis on specialized knowledge. Ben Bernanke was expert in the monetary origins of the Great Depression, yet he missed the onset of the Great Financial Crisis. Janet Yellen was renowned for her work in labour markets but was mystified by the flattening of the Phillips Curve relationship between unemployment and inflation. All these themes come together in how central banks de-emphasized monetary aggregates in recent decades.

Central bankers’ recent bungling of inflation demonstrates these financial emperors have no clothes, a lesson learned that will be good for the rest of us in the long run.

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Source: PHILIP CROSS | FINANCIAL POST

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