Central banks face the same nightmare almost everywhere: a mixture of slower growth and inflationary supply shocks that together threaten stagflation. So far, they are tackling the problem in different ways.
Interest rates have already risen in Norway and many emerging economies, while the US Federal Reserve and the Bank of England have taken steps to tighten monetary policy. In contrast, the European Central Bank and the Bank of Japan are sitting tight for now.
These different responses reflect the difficulty of dealing with what Megan Green of Harvard University calls any central bank’s “worst nightmare” – a time when global economic forces are slowing growth and increasing inflation.
The orthodox economic point of view is that central banks should do nothing to offset inflation caused directly by a supply shock, such as the rise in oil prices this week to a seven-year high. As Dhaval Joshi, chief strategist at BCA Research, puts it: “It is extremely dangerous to respond to inflation generated by a supply shock with a tighter monetary policy.
The central problem is that monetary policy generally works by raising or lowering economic demand. If spending grows too quickly and generates inflation, higher interest rates dampen the willingness of businesses and households to consume or invest by increasing the cost of borrowing.
The same is not true when prices rise because supply chains have broken down, energy prices rise, or there are labor shortages. In such cases, monetary policy is ill-suited to cope with the shock.
As Andrew Bailey, Governor of the Bank of England, said: “Monetary policy won’t increase the supply of semiconductor chips, it won’t increase the amount of wind (no, really), and nor will it produce heavy truck drivers.
Sometimes restrictive monetary policy has worked. During the oil shock of the 1970s, firm measures by the Bundesbank prevented inflation from taking root in the economy.
The West German central bank then got it right, wrote former ECB chief economist Otmar Issing, because its tight monetary stance gave “unambiguous indications to other economic decision-makers as well as to the public and, over a period of three years, maintained a strong sense of direction ”.
Yet in 2011, when the ECB misled the Bundesbank’s unwavering resolve by raising interest rates during a food and energy supply shock, it committed what is now considered a catastrophic mistake that amplified the eurozone crisis that year. The difference in 2011 was that there had been no spillover effects from the supply shock, so the rate hike was unnecessary and damaging.
Ten years later, the world’s central banks are faced with an equally delicate balancing act: tightening too soon and they could stifle the recovery; tighten too late and inflation could take hold.
In the United States, Fed Chairman Jay Powell admitted last week that the Fed was surprised by the severity of the supply bottlenecks. Still, the Fed also said it would “examine” the price hikes that would follow, firmly believing they would fade over time. This view, for now, is supported by longer-term market measures of inflation expectations.
“What would turn this into a more pernicious and dangerous situation,” said David Wilcox, senior researcher at the Peterson Institute for International Economics and former Fed staff member, “would be if there was a break in inflationary psychology. “which has led to companies raising prices and wages pending similar action from competitors.
This could then snowball into a “toxic” situation where inflation expectations skyrocket.
With the US economy expected to grow nearly 6% this year and interest rates close to zero, Fed officials have already signaled at least three interest rate hikes before the end of 2023. s ” adapt to erased supply chains and higher costs by raising their own prices, triggering an inflationary chain reaction.
“It’s something I spend a lot of time thinking about,” Raphael Bostic, chairman of the Atlanta branch of the Fed, said last week.
Meanwhile, in the UK, the Bank of England is focusing on the labor market. If it sees wages rising without productivity improving, this may indicate that demand is always greater than supply. In this case, he indicated that monetary action might be necessary.
In the euro area, where unemployment is higher than in the UK and labor shortages less acute, the approach is slightly different. ECB President Christine Lagarde last week distanced herself from other central banks’ turn to tighten monetary policy, despite eurozone inflation peaking level for 13 years.
Still, Lagarde said it was important to “address temporary supply-induced inflation, as long as inflation expectations remain anchored” and wages do not soar. She added that there were still few signs of either.
How long this stays the case is an open question. Clemens Fuest, director of the Ifo Institute, warned: “We don’t see any wage agreements that [lead to] higher inflation, but at the same time the unions are waking up and demanding higher wages.
In Japan, the difference in approach is even more marked. There, the central bank, which has long fought deflation, would see a rise in inflation and inflation expectations caused by a supply shock as useful.
Given the uniqueness of the global economic shock caused by Covid-19, the rate at which growth in large economies is slowing and inflation is increasing, and the difficulties of dealing with stagflation, there will likely be many more twists and turns in the central bank. Politics.
“We are not dealing with demand-driven inflation. What we’re really going through right now is a massive supply shock, ”said Jean Boivin, former deputy governor of the Bank of Canada now at the BlackRock Investment Institute. “How to deal with this is not as simple as just dealing with inflation. “