Central banks almost everywhere face the same bad dream: a mix of slowing growth and inflationary supply shocks that together threaten stagflation. So far, they are confronting the problem in different ways.
Interest rates have already risen in Norway and in many emerging economies, while the US Federal Reserve and the Bank of England have made moves 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 Harvard University’s Megan Green calls every central bank’s “worst nightmare” — a moment when global economic forces are both slowing growth and increasing inflation.
The orthodox economic view is that central banks should do nothing to offset inflation caused directly by a supply shock, such as this week’s rise in oil prices to a three-year high. As Dhaval Joshi, chief strategist at BCA Research, puts it: “Responding to supply shock-generated inflation with tighter monetary policy is extremely dangerous.”
The central problem is that monetary policy typically works by raising or lowering economic demand. If spending is growing too fast and generating inflation, higher interest rates dampen the willingness of companies and households to consume or invest by increasing the cost of borrowing.
The same is not true when prices are rising because supply chains have broken, energy prices are increasing or there are labour shortages. In such cases, monetary policy is ill-suited to dealing with the shock.
As Andrew Bailey, governor of the Bank of England, has said: “Monetary policy will not increase the supply of semiconductor chips, it will not increase the amount of wind (no, really), and nor will it produce more HGV drivers.”
Sometimes restrictive monetary policy has worked. During the 1970s oil shock, tough Bundesbank action kept inflation from becoming ingrained in the economy.
West Germany’s central bank got things right then, former ECB chief economist Otmar Issing has written, because its tight monetary stance gave “unambiguous guidance to other economic decision makers as well as the public and, over a period of three years, kept a firm sense of direction”.
Yet in 2011, when the ECB aped the Bundesbank’s steely resolve by raising interest rates during a food and energy supply shock, it made what is now considered a catastrophic error that amplified the eurozone crisis that year. The difference in 2011 was that there were no knock-on effects from the supply shock, so the rate rise was unnecessary and damaging.
Ten years on, global central banks face a similarly delicate balancing act: tighten too soon and they could snuff out recovery; tighten too late and inflation could become entrenched.
In the US, Fed chair Jay Powell admitted last week the Fed had been surprised by the intensity of supply bottlenecks. Yet the Fed has also said it will “look through” the ensuing price rises given its firm belief they will fade over time. That view, for now, is supported by longer-term, market measures of inflation expectations.
“What would transform this into a more pernicious and dangerous situation,” said David Wilcox, a senior fellow at the Peterson Institute for International Economics and a former Fed staffer, “would be if there is a break in the inflationary psychology” that led to companies raising prices and wages in the expectation of similar moves by competitors.
This could then snowball into a “toxic” situation where inflation expectations spiral higher.
With the US economy forecast to expand almost 6 per cent this year, and interest rates near zero levels, Fed officials have already signalled at least three interest rate increases before the end of 2023. Whether an earlier move is required depends in part on whether companies adapt to gummed-up supply chains and higher costs by raising their own prices, setting off an inflationary chain reaction.
“It is something that I am spending a lot of time thinking about,” Raphael Bostic, president of the Atlanta branch of the Fed, said last week.
Meanwhile, in the UK the Bank of England is focusing on the labour market. If it sees wages rising without productivity improving, this may signal that demand is persistently stronger than supply. In that case, it has indicated monetary action may be needed.
In the eurozone, where unemployment is higher than in the UK and labour shortages less acute, there is a slightly different approach. ECB president Christine Lagarde last week distanced it from the shift by other central banks towards tighter monetary policy, despite eurozone inflation reaching a 13-year high.
Still, Lagarde said it was important to “look through temporary supply-driven inflation, so long as inflation expectations remain anchored” and wages do not spiral upwards. She added there were few signs of either, yet.
How long that remains the case is an open question. Clemens Fuest, head of the Ifo Institute, cautioned: “We do not see wage settlements that would [lead to] higher inflation, but at the same time the unions are waking up and calling for higher pay.”
In Japan, the difference in approach is starker still. There the central bank, which has long fought against deflation, would consider a rise in inflation and inflationary expectations caused by a supply shock to be helpful.
Given the uniqueness of the global economic shock wrought by Covid-19, the speed with which growth in major economies is slowing and inflation is rising, and the difficulties of dealing with stagflation, there are likely to be many further twists and turns in central bank policy.
“We are not dealing with demand-push inflation. What we are really going through right now is a massive supply shock,” said Jean Boivin, a former Bank of Canada deputy governor now at the BlackRock Investment Institute. “The way to deal with this is not as straightforward as just dealing with inflation.”
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