Fighting Inflation: Are Central Banks Going Too Far, Too Fast?

Sharpening their bills and displaying claws, the world’s central banks adopted a hawkish stance this week. Backed by sharp interest rate hikes and currency intervention, they have used specific language to announce their sole goal of defeating the scourge of inflation.

In one of the most abrupt shifts in global economic policy-making in decades, central bankers say they have enough of rapid price increases and are insisting they are ready to work to restore price stability, at nearly any cost.

But after a week of sensational announcements from central banks around the world, at least some economists are starting to wonder – are they going too far, too quickly?

The US Federal Reserve has been the most significant player in this shift in mood. On Wednesday, it raised its benchmark interest rate by 0.75 percentage points to a range of 3 to 3.25 percent. At the beginning of the year, that rate was close to zero.

By raising interest rates, central bankers do not seek to reduce peak rates of inflation caused by rising gas and food prices, but rather to ensure that inflation does not continue to rise. © Kiyoshi Ota / Bloomberg

The Fed has signaled that this is far from the end of its monetary policy tightening, with rate-setting committee members predicting interest rates will expire in 2022 between 4.25 and 4.5 percent – the highest since the 2008-2009 financial crisis.

In the summer, Federal Reserve Chairman Jay Powell spoke of rising borrowing costs ending in a “soft landing” of the economy without a recession and a gentle slide in inflation. On Wednesday, he admitted that was unlikely. We have to keep inflation behind us. “I wish there was a painless way to do this,” Powell said.

The Fed’s plan to curb consumer and business spending in an effort to curb domestic inflation has been repeated elsewhere, even if the reasons for higher inflation are different. In Europe, the extraordinary prices of natural gas sent core inflation rates to similar levels as in the United States, but core inflation is much lower. In emerging economies, falling currency values ​​against the US dollar, which hit a 20-year high this week, pushed up import prices.

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Sweden’s Riksbank kicked off the tradition on Tuesday with a 1 percentage point increase in its interest rate to 1.75 percent, the biggest rate hike in three decades. Switzerland, Saudi Arabia and the United Arab Emirates also announced an increase of 0.75 percentage points each, which for Switzerland means ending the period of negative interest rates that began in 2015. On Thursday, the Bank of England raised the key rate by 0.5 percentage points to 2.25 percent, The highest level since the financial crisis, with close promises of higher interest rates in the future.

Even in Japan, which has long adopted negative interest rates, the authorities felt the need to work to curb inflation. The Ministry of Finance intervened in the currency markets to support the yen on Thursday and limit the rise in import prices. It took what he called “decisive action” to address the strength of the US dollar that was driving the country’s core inflation rate to a very unusual rate of 2.8 per cent in August.

Economists at Deutsche Bank note that for every single central bank worldwide that currently cuts interest rates, there are now 25 that raise interest rates – a rate well above normal levels not seen since the late 1990s, when many central banks were granted independence. to set monetary policy.

Graph showing the 12-month turnover ratio of the number of World Central Bank hikes to cuts, indicating that many central banks are raising interest rates

Nathan Sheets, Citi’s global head of international economics and a former US Treasury official, says central banks are “moving so fast that with these price increases in place, there hasn’t really been enough time for them to judge the reaction to the effects on the economy.” “.

Central bankers have been reluctant to admit that they made mistakes in keeping interest rates too low for too long, noting that these assessments are much easier to take advantage of by taking advantage of hindsight than they are in real time. But now they want to take action to demonstrate that even if they are late in starting to take action against inflation, they will be “strong” enough, to use the word BOE, to bring down inflation.

Powell was clear that the US central bank would not fail in its job. “We will continue that until we are sure that the job is done,” he said on Wednesday. Sweden’s Riksbank has been characteristically candid in its assessment. “Inflation is very high,” she said. “Monetary policy now needs to be tightened further to bring inflation back to target.”

The new stance on monetary policy was developing until 2022 as the problem of inflation became more persistent and difficult for central bankers. By the time many gathered in Jackson Hole in August for their first annual convention, the mood had shifted decisively toward the larger action now being played around the world.

Jackson Hole: John Williams of the New York Federal Reserve with Fed Governor Lyle Brainard and President Jay Powell, who said
Jackson Hole: New York Fed John Williams with Fed Governor Lyle Brainard and President Jay Powell, who said, ‘We have to get inflation behind us. I wish there was a painless way to do it’ © Jim Urquhart / Reuters

Christian Keeler, head of economic research at investment bank Barclays, says that “since Jackson Hole, central bankers have decided they want to err on the side of hawks.”

For the first time in decades they may have become afraid of losing control of [inflation] process, says Keeler, highlighting how central bankers now say they want to avoid the mistakes of the 1970s. Central banks “are making decisions that carry a lot of risk and that sounds better if everyone else is doing it. The result is a simultaneous tightening.”

With the new situation, markets estimate that by June of next year, interest rates will rise to 4.6 per cent in the US, 2.9 per cent in the eurozone, and 5.3 per cent in the UK – expectations that range from 1.5 And 2 percentage points higher than at the beginning of August.

Chart: Market expectations of interest rates rise in June

By raising interest rates, central bankers are not seeking to reduce the rates of peak inflation that have resulted from rising gas and food prices outside the United States, but they are aiming to ensure that inflation does not continue at an alarmingly higher rate than their own. Objectives. This can happen if companies and employees start to expect higher inflation, which leads to higher prices and demand for higher wages.

They are willing to ensure that there is pain in the economic downturn to prove that they are credible in reaching their inflation targets.

Sheets says that after misreading inflation last year, central banks now prefer to exaggerate it. They weigh the prospects of a recession against the risks of a persistent inflation crisis that would undermine their credibility. “In general they feel. . . This is a risk they have to take.”

An additional complication is that the models used by central banks – which did not anticipate such rapid price increases as the pandemic subsided and the war in Ukraine began – no longer do well in describing economic events.

Ukrainian artillery fired at Russian troops.  The models used by central banks — which did not anticipate such rapid price hikes as the pandemic subsided and the war in Ukraine began — no longer do well in describing economic events.
Ukrainian artillery fired at Russian troops. Models used by central banks – which did not anticipate such rapid price hikes as the pandemic subsided and the war in Ukraine began – no longer do well in describing economic events © Ihor Tkachov / AFP / Getty Images

Eli Henderson, an economist at Investec, worries that “the usual tools and models, which would guide such [central bank] The analysis, can no longer be relied upon because it now operates in parameters outside the ranges that were estimated.”

In this unknown world, Jennifer McKeown, head of global economics at Capital Economics, thinks it’s hard to argue that central banks are going too far.

“While this is the most aggressive tightening cycle in many years, it is also true that inflation is higher than it has been in decades,” she says. “Inflation expectations have risen and labor markets are tight, so central banks are concerned about the potential for second-round effects from energy prices to wages and core inflation.”

But a growing number of economists, led by some big names such as Morris Obstfeld, the former chief economist of the International Monetary Fund, believe that central banks are now excessive in their rate hikes and that the impact of all this tightening will be global. Recession. The World Bank also expressed similar concerns this week.

“Central banks have lost confidence in their ability to accurately forecast inflation,” says Antoine Buffett, an economist at ING, which has led them to focus more on actual inflation rates today.

Women work in an office on Bond Street, London, during the 1973-1974 power outage.  Central bankers now say they want to avoid the mistakes of the 1970s
Women work in an office on Bond Street, London, during the 1973-1974 power outage. Central bankers now say they want to avoid the mistakes of the 1970s. © Evening Standard / Getty Images

“Combine this with the fact that they seem to think it costs less to over-tighten their policy than under-target and you have a recipe for over-tightening,” he explains. “I would describe this policy choice as almost an override by design.”

According to Holger Schmieding, chief economist at investment bank Berenberg, “Monetary policy operates with a lag, [so] The danger is that the Fed will only notice belatedly that it has gone too far if it now raises interest rates beyond 4 per cent,” leading to an unnecessarily long and deep recession.

But as many economists explain, no one really knows what is too far and not far enough in this environment. Therefore, central banks want to ensure that inflation is eliminated, allowing them to correct course and lower interest rates later if necessary.

Krishna Guha, vice president at Evercore ISI, says there is a “grave risk” that central banks are over tightening, but stresses that the Fed is right to err on the side of doing too much.

“Globally, as well as in the United States, it is probably better to overdo it than underestimate it and risk a return of the 1970s,” Guha says. “But that of course makes the outcome of overdoing it more likely.”

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