Liquidity yesterday, inflation today

The inflation that is emptying the pockets of Europeans was not just caused by the energy crisis or by the Russian invasion of Ukraine. The events where the matches that ignited the flame, but the fuel had been ready for some time: excess liquidity all over the world, at very low interest rates. To understand the origins of the phenomenon, we need to delve further into the past, even before the Covid-19 pandemic, at look at quantitative easing. This is the perspective offered by Franco Bruni, Emeritus at the Bocconi Department of Economics and Vice-President of ISPI, in his latest book "Beyond the Pillars of Hercules. Rethinking the rules of monetary policy" released by Egea last month. "In Europe - explains Bruni - there was strong insistence from the ECB in keeping rates negative and quantitative easing abundant in 2017-2018 as well, when growth was already picking up and inflation was fast approaching the 2% target".

Bruni's essay, the author recounts, highlights "the considerable slowness with which monetary policies have tackled price increases, both in the United States and Europe: even when there were clear signs of acceleration in the cost of living, the central banks postponed the rate hikes. Inflation began to rise in 2021, but if in the US the Federal Reserve intervened only months later, in Europe the European Central Bank acted even more slowly". One of the original contributions of the book, he explains, is going through of the minutes of ECB board meetings: "I went to see how the discussions of the directorate were summarized, trying to understand how every time the increase in interest rates was postponed despite inflation already being substantially at 2% and the economy recovering. In 2018 this was sensational: the change in monetary policies was procrastinated with all kinds of excuses, going so far as to say that the acceleration in prices was due to the shopping for the Easter holidays".

Abundant criticism of quantitative easing can be found in this work, just like in his much earlier L'Acqua e la Spugna (The Water and the Sponge), published by Egea thirteen years ago. "Of course, Mario Draghi knows these criticisms well", says the Bocconi emeritus, who was a fellow student of the former ECB governor and Italian prime minister. The mistake, Bruni explains, "was considering the purchase of government bonds as a sort of permanent monetary policy tool", a mechanism that made monetary policy "less independent of budgetary policy and a way to make life easy for governments, which issued treasuries knowing someone would buy them. A central bank is made to intervene when needed, but immediately afterwards it must know when to stop: by its nature, monetary policy is a short-term affair because in the long run a central bank must only ensure that inflationary expectations are low and constant". Instead, especially in Europe, "the accumulation of public securities in the belly of the ECB has become almost structural, discombulating the functions of the central bank, and shifting it towards growth objectives that must be pursued through other instruments and policies, thus reducing its independence in reacting to shocks".

ECB and Fed should tie their own hands to avoid a repetition of the current situation in the future. Bruni suggests that central bankers must "tie their hands" with an array of rules and best practices that prevent them from erring the course. "Unlike many of my colleagues - he explains - I'm not angry with at central banks for doing acrobatic moves to stop inflation. But when they have won this battle, they will have to start thinking how to avoid derailing again". There are two fronts: rules are needed to anchor interest rate movements by limiting abrupt and lasting excesses in one direction or the other, and flexible constraints are needed to limit the possibility of the central bank accumulating private and especially public assets for too long. "The central bank - explains Bruni - by its very nature must concentrate on regulating the liquidity of the system, granting and withdrawing credit. This involves, from time to time, the buying of treasuries. Securities that, in the balance sheets of central banks, must act as temporary buffers, capable of inflating and deflating rapidly".

Limits that cannot be set by governments, so as not to threaten the independence of central banks: "They have an interest themselves in acknowledging these constraints and tying their own hands to be more credible in the eyes of markets when they say they are pursuing financial stability and low inflation". One way, Bruni points out, could for central banks to start communicating together, globally: "In a global context, there should be the principle of collaboration and coordination between all central banks given that the effects of monetary policies do not remain within the jurisdictions of the Fed or of the ECB but spread around the world. Markets need to know that central banks coordinate their actions; if the latter start making joint announcement, they will have more difficulty in contradicting themselves later". In short, he concludes, even if central bankers consulted continuously on major decisions, it would be necessary to change their code of conduct in the coming years and "at least some strategic decisions should be coordinated and then made public through a global press release: this would make everything more binding and believable".