Central banks are facing the same bad dream almost everywhere: a mixture of slower growth and inflationary supply shocks threatening 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 taken steps to tighten monetary policy. In contrast, the European Central Bank and the Bank of Japan are stuck for the time being.
These differing 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 growing and inflation rising.
The orthodox economic view is that central banks should do nothing to curb inflation caused directly by a supply shock, such as the rise in oil prices to a peak of seven years. As Dhaval Joshi, chief strategist at BCA Research, puts it: “It is extremely dangerous to react to shock-generated inflation.”
The central problem is that monetary policy usually increases or decreases economic demand. If spending grows too fast 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 does not apply if prices rise because supply chains have broken, energy prices rise or there is a shortage of labor. In such cases, monetary policy is not appropriate to deal with the shock.
Like Andrew Bailey, Governor of the Bank of England, said: “Monetary policy will not increase the supply of semiconductor chips, it will not increase the amount of wind (no, really), nor will it produce more HGV drivers.”
Sometimes restrictive monetary policy worked. During the oil shock of the 1970s, the harsh Bundesbank action did not root inflation into the economy.
The central bank of West Germany has got things right, said former ECB chief economist Otmar Issing writing, because its strict monetary stance ‘has given unequivocal guidance to other economic decision-makers as well as the public and, over a period of three years, has a solid sense of direction’.
But in 2011, when the ECB adopted the Bundesbank’s decision by raising interest rates during a shock to food and energy supply, it made a catastrophic mistake that exacerbated the eurozone crisis that year. The difference in 2011 was that there were no knock-on effects from the supply shock, so the increase was unnecessary and damaging.
Ten years later, the global central banks are facing a similar delicate balance: to sharpen and they can recover; too sharpened and inflation can be hedged.
In the US, Fed Chairman Jay Powell allowed last week the Fed was surprised by the intensity of the bottlenecks in supply. However, the Fed also said it would review subsequent price increases, given its firm belief that they would fade over time. This view is currently supported by market measures of long-term inflation expectations.
“What would turn it into a more damaging and dangerous situation,” says David Wilcox, a senior fellow at the Peterson Institute for International Economics and a former Fed staffer, “if there is a break in inflationary psychology” companies which increases prices and wages in anticipation of similar movements by competitors.
It can then snowball into a ‘toxic’ situation where inflation expectations rise higher.
With the US economy forecasting to expand nearly 6 percent this year and interest rates close to zero, Fed officials had already indicated at least three rate hikes before the end of 2023. Whether an earlier move is needed depends in part on whether companies adapt to accumulated supply chains and higher costs by raising their own prices, resulting in an inflationary chain reaction.
“This is something I spend a lot of time on,” Raphael Bostic, president of the Fed’s Atlanta branch, said last week.
Meanwhile, the Bank of England in the UK is focusing on the labor market. If wages rise without improving productivity, it could indicate that demand is consistently stronger than supply. In that case, it indicated that monetary action may be necessary.
In the eurozone, where unemployment is higher than in the UK and labor shortages are less sharp, there is a slightly different approach. Christine Lagarde, President of the ECB, last week it distanced from the shift by other central banks to tighter monetary policy, despite eurozone inflation peaking at 13 years.
Yet Lagarde said it was important to “look at temporary supply-driven inflation, as long as inflation expectations remain anchored” and wages do not rise. She added that there were still few signs.
How long is it remains the case is an open question. Clemens Fuest, head of the Ifo Institute, warned: ‘We do not see any wage settlements [lead to] higher inflation, but at the same time the unions are waking up and asking for higher salaries. ”
In Japan, the difference in approach is growing. There, the central bank, which has long fought against deflation, would consider a rise in inflation and inflationary expectations caused by a supply shock useful.
Given the uniqueness of the global economic shock caused by Covid-19, the speed with which growth in large economies is slowing and inflation rising, and the difficulties in dealing with stagflation, there are probably many more twists and turns in central bank policy.
‘We have nothing to do with demand inflation. What we’re really experiencing right now is a huge supply shock, ” said Jean Boivin, a former deputy governor of the Bank of Canada, now at the BlackRock Investment Institute. ‘The way to deal with it is not as simple as dealing with inflation.