Daily Management Review

Central Banks Have Not Yet Scripted The Concluding Act Of The War Against Inflation Even As Threats Grow


Central Banks Have Not Yet Scripted The Concluding Act Of The War Against Inflation Even As Threats Grow
Although major central banks are well into their campaign to raise interest rates in an effort to combat inflation, researchers warn that financial markets may yet see disruptions along the way because price increases are proving more difficult to moderate than anticipated.
The Bank of England, the European Central Bank, and the U.S. Federal Reserve are all continuing rising interest rates, and decision-makers are transparent about the enormous uncertainty that surrounds their forecasts and the possibility that they may need to take additional action.
However, all believe that the interest rate for this cycle of monetary policy tightening has peaked, and they continue to hold fast to their predictions that inflation will decline steadily over the next year or two without significantly slowing down economic activity.
Top global policymakers and economists have responded to that viewpoint with skepticism, predicting a world where persistent labor shortages, rifts in the global supply, and shaky financial markets may impose a choice between greater and longer-lasting inflation or a devastating recession to fix it.
"We are going to be hit by more supply shocks, and monetary policy faces much more serious tradeoffs," International Monetary Fund First Deputy Managing Director Gita Gopinath said in a forum during the IMF and World Bank spring meetings in Washington last week. This is because the global economy is becoming more fragmented as a result of the COVID-19 pandemic.
Others who believe the three leading central banks' claim of largely cost-free disinflation rests on weak ground echoed her sentiments.
It definitely breaks with the past. Gopinath pointed out that "no historical precedent" existed for high inflation to be curbed without leading to an increase in unemployment.
The claim that this time will be different is further supported by the belief that inflation in the post-pandemic world will behave similarly to how it did in the past, namely tepidly, with an anchor lower than higher and with little need for poor output or rising unemployment to restrain it.
While avoiding the label "transitory," this point of view nevertheless sees the current inflation as at least somewhat the result of ongoing adaptation to the pandemic's once-in-a-century shock and the additional strain the Russian invasion of Ukraine has put on commodities prices.
As these distortions pass and earlier inflation tendencies reappear, interest rates are being hiked to restrain demand sufficiently to reduce price pressures and maintain public inflation expectations under control.
Notably, the median estimate of Fed policymakers for a long-run policy rate consistent with stable inflation has remained at 2.5% since June 2019, when belief in the idea of a largely deflationary world peaked. This is despite one of the most severe blows to the global economy, rising geopolitical tensions, and an ongoing war in Europe.
How central banks are framing the future is implied in the promise of declining inflation together with a gradual restoration to the pre-pandemic condition of affairs.
Only the BoE, the British central bank, predicts that a recession—and a relatively light one at that — will be required to reduce inflation.
With no change in the unemployment rate, the ECB anticipates victory in the war against inflation. Officials from the U.S. central bank have projected a minor increase in the unemployment rate this year from its nearly historic low of 3.5% and gradual but steady economic growth.
In light of that scenario, Fed members hinted last month that this tightening cycle would end with one more quarter-percentage-point rate hike at their meeting on May 2-3, bringing the policy rate up to the range of 5.00%-5.25%.
A Fed halt would send a strong message that the era of synchronized tightening is over and that central bankers are entering a holding pattern while they wait for the effects of tighter financial conditions and normalizing economies to be felt on prices. The BoE and ECB are probably further away from rate-hike pauses.
The narrative and the data diverge at this point.
Inflation has significantly decreased in both Europe and the United States. However, they have been fueled by the most erratic factors, namely energy prices, while underlying inflation, notably in the sectors that employ the most people, has moved more slowly.
While the primary ECB forecast is for declining earnings, improved supply chains, and reduced energy prices to bring down inflation, some officials are concerned that this won't be enough in a world with a labor shortage.
"It is not a given that we will return to price stability over the medium term," even after the fastest rate hikes on record, Bundesbank President Joachim Nagel warned last week during a speech at the Peterson Institute for International Economics in Washington.
Martins Kazaks, the head of Latvia's central bank, stated that a number of variables continue to exert pressure on prices, making the danger of a recession still "non-trivial."
"Corporate profit margins still remain high, wage pressures are strong and the labor market is tight," Kazaks told Reuters. "All these point to the view that inflation persistence is relatively strong and that rates still need to go up."
For the Fed, many policymakers present varying perspectives on the factors that will reduce inflation as high interest rates gradually reduce demand.
However, the Fed's staff and an increasing number of traders and economists don't see it working out without a recession, which Jason Furman, a Harvard University professor who served as the Obama administration's top economic adviser from 2013 to 2017, believes is implied in policymakers' projections even if they don't use the word.
The unemployment rate in the United States has never increased by one percentage point during a nine-month period without a recession, and the 2023 expected GDP growth of 0.4% would result in output shrinking for the remainder of the year after a good first quarter.
"I think they do have a coherent story, which is that they're going to cause a recession," Furman told Reuters on the sidelines of the IMF and World Bank meetings. "You don't hear it very clearly ... I think they also have a hope for a 'soft landing,' and that probably shows up in being a little bit more timid in their policy" than might ultimately prove necessary.
The scenario to which Furman was alluding is one in which monetary tightening suppresses inflation without causing a recession.
The riskiest steps could be necessary after those if the anticipated ones up to this point have prevented a significant shock to the economy or financial markets.
The Fed "is not going to quit until the labor market quits," said Randall Kroszner, a former Fed governor who is now a professor at the University of Chicago's Booth School of Business. With interest rates now moving above the rate of inflation in the U.S. and becoming ever more restrictive, "that is where the rubber is going to hit the road ... I think it is going to be very hard to avoid something moving down and moving down relatively quickly."