Tough economic times lie ahead

Central banks are determined to bring inflation back under control. This was the message from Jay Powell, chairman of the Federal Reserve, and Isabel Schnabel, an influential member of the board of directors of the European Central Bank to the Jackson Hole Symposium last week. So why were the central banks so clinging to this message? Are they right? And above all: what can it mean for future policy and the economy?

“Reducing inflation is likely to require a sustained period of below-trend growth. . . While higher interest rates, slower growth and softer labor market conditions will bring inflation down, they will also hurt households and businesses. These are the unfortunate costs of curbing inflation. But if price stability is not restored, it would mean much more pain.” These were the words of Powell. Again, Schnabel argued that central banks need to act decisively as expectations threaten to become entrenched, inflation has been persistently too high and the costs of controlling it will rise the longer action is delayed. There are risks of doing too much and too little. Still, “determination” to act is a better choice than “prudence”.

It is not difficult to understand why central bankers say what they say. They have a clear mandate to control inflation that they have failed to deliver. Not only headline inflation, but also core inflation (excluding energy and food) has been above target for some time. Of course, this unfortunate outcome has a lot to do with a series of unexpected supply shocks, in the context of the post-pandemic shift to commodity consumption, energy restrictions and now the war in Ukraine. But the scissors have two blades: demand, but also supply. Central banks, especially the Fed, have been holding on to the ultra-accommodative policies of the pandemic for too long, even though the US fiscal policy has also been too expansionary.

In an important analysis Ricardo Reis from the London School of Economics points to four reasons why this happened. First, central banks repeatedly interpreted supply shocks as temporary interruptions, not as quasi-permanent effects on potential output. Second, they misinterpreted short-term expectations, focusing too much on the mean rather than the shift to higher expectations at the top of the distribution. Third, they tended to view credibility as an infinitely deep well, rather than a shallow well that needs to be refilled immediately. So they failed to notice that the distributions of long-term inflation expectations also shifted against them. Finally, their belief in low neutral interest rates made them worry too much about deflation and too little about the return of inflation. The central point is that these were intellectual errors. So, in my opinion, the lack of attention has been paid to monetary data.

Essentially, central banks are catching up because they fear they risk losing credibility and if they did, the cost of regaining it would be much higher than it would be to intervene now. This fear is reinforced by the risks to wage inflation resulting from the combination of high price inflation with strong labor markets. The fact that higher energy prices raise the prices of almost everything makes this risk greater. This could then trigger a second-round wage-price spiral.

They are right to take this judgment. A shift to an era of high and unstable inflation in the style of the 1970s would be a disaster. Yet there is indeed a risk that the slowdown in economies, caused by a combination of falling real incomes and tightening financial conditions, will cause an unnecessarily deep slowdown. Part of the problem is that calibrating monetary tightening is particularly difficult these days because it involves raising short-term interest rates while shrinking balance sheets at the same time. A bigger one is that policymakers haven’t been confronted with anything like this for four decades.

In the US, there is a particularly optimistic view of “immaculate disinflation” enunciated by the Federal Reserve. This debate focuses on whether it is possible to reduce the pressure on the labor market by reducing vacancies without increasing unemployment. An important paper by Olivier Blanchard, Alex Domash and Lawrence Summers argues that this would be unprecedented. The Fed has responded by saying that everything is unprecedented now, so why not this too? In response to this, the authors of the original article: persevere that there is no good reason to believe that things are so unprecedented. Think about it: how can one expect a general monetary tightening to affect only companies with vacancies? It will certainly also affect companies that would then have to lay off employees.

If the planned tightening of monetary policy is likely to trigger a recession in the US, what could happen in Europe? The answer is that recessions are likely to be deep there, as the energy price shock is so great. Here too, the balance between the impact on supply and demand is unclear. If the impact of higher energy prices on the former is greater than on the latter, demand will also have to be slowed down.

Monetary policy will play a part in the European story. But the core of the current crisis is the energy shock. Central banks cannot do anything directly about such real economic disruptions. They must stick to their mandate of price stability. But a huge effort needs to be made to protect the most vulnerable from the crisis. Moreover, not only people, but also countries will be among the most vulnerable. A high level of fiscal cooperation will be needed in the eurozone. A political understanding of the need for solidarity within and between countries is a precondition.

A storm has come from eastern Europe. It must be weathered. How best to do that will be the subject of future columns.

martin.wolf@ft.com

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