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The US central bank, the Federal Reserve, has recently signalled that it will keep interest rates high for as long as it takes to bring inflation down to its 2% target.
Other major central banks, such as the UK’s Bank of England and the European Central Bank (ECB), are likely to follow suit. But rate-setters face some dilemmas when it comes to balancing the use of interest rates to slow the economy versus the risk of a recession.
In an August 25 speech during the annual Jackson Hole Symposium, an influential summer gathering of central bankers, policymakers and academics, chairman Jerome Powell indicated that the Fed is not yet convinced it has won the battle against inflation. This is despite the US headline rate of inflation falling from 8.5% in March 2022 (when the Fed started raising rates) to 3.2% in July.
Powell did suggest the central bank might start to slow the pace of rate rises after 11 consecutive rises in interest rates to 5.5% in little more than a year. As in other regions, such as the UK and EU, recent rapid increases have reversed around a decade of ultra-low rates.
This leads to even higher interest rates being charged by financial institutions, and so is designed to slow the economy. But if taken too far, it could also trigger a recession.
The Jackson Hole meeting is closely watched by financial markets, governments and the media for indications of the long-term direction of monetary policy, and for deeper insights into the challenges facing the world’s central banks. And so the speech was a disappointment to financial markets, which have been rocked by recent sharp interest rates hikes.
For more than a decade, stock markets boomed on the back of near-zero interest rates, with the US Dow Jones Industrial Average (DJIA) quadrupling. But as the Fed started raising rates, the DJIA plummeted by 20%, with a short-lived recovery that soon fizzled out. And so, market hopes for a rate cut this year have been dashed – although Powell did suggest that how far and how fast rates would rise remains up for debate.
Indeed, Powell warned of the potential for more pain to come for households and businesses either way. Reducing inflation inevitably leads to below-trend economic growth, which causes companies to reduce pay and hiring activity. Outlining central banks’ current balancing act, he said: “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
Similar sentiments were echoed by ECB president Christine Lagarde at Jackson Hole. The Eurozone is also in the middle of sharply raising interest rates, despite slumping economic growth. While Largarde emphasised that the ECB must aim to keep inflation at 2% in the medium term, she also said: “There is no pre-existing playbook for the situation we are facing today – and so our task is to draw up a new one.”
Indeed, it remains to be seen if the world economy is entering a new phase of high inflation and weak growth, or whether the conditions that have led to the recent inflationary surge are temporary.
Are we in a new economic era of high inflation?
At Jackson Hole, Powell highlighted the need to ensure that public expectations of continued rapid inflation do not become entrenched. This could trigger a wage-price spiral that could get out of control. He warned that the cost of inaction would, therefore, be even higher.
Indeed, all of the major central banks, including the Fed, dramatically underestimated the effect of the pandemic on inflation. They have been criticised for not acting in time and are now scrambling to rapidly increase interest rates. But why didn’t the central banks’ economic forecasting models predict rising inflation?
Gita Gopinath, the IMF deputy director, argued at Jackson Hole that central bank models are outdated because they underestimated the long-term effects of supply-side disruptions. She suggested that recent failures to stop inflation rises fast enough have seriously damaged central banks’ credibility. As a result, they can no longer hope to ignore short bursts of inflation without serious consequences. She also raised the possibility that, in the long term, weaker economic growth might indeed be the price of curbing inflation.
Several policymakers, including Barack Obama’s former economic adviser Jason Furman, also in attendance at Jackson Hole, have even suggested that revising central banks’ target rate of inflation to 3% from 2% would be no bad thing. This is still heresy for most central bankers, who believe making such a significant change to their remit would damage their credibility even more.
Dilemmas facing central banks
The Jackson Hole meeting highlighted three key dilemmas for central banks.
First, is the medicine (rate rises) working? While inflation has fallen, core rates in the UK, EU and US are still well above the 2% target. It’s unclear whether slowing demand in the economy is the right approach when inflation has been caused by “supply-side disruption” (pandemic-era supply shortages and the commodity-related effects of Russia’s invasion of Ukraine left too much money chasing too few goods).
And since higher interest rates can take up to 18 months to work, it is hard to judge yet whether economic growth has slowed enough due to higher rates.
Second, it’s unclear how much more economic pain it will take to contain inflation. This question is particularly acute for the ECB and the Bank of England – economic growth in the EU and UK has been much more anaemic and inflation higher than in the US.
Finally, central banks face real challenges in trying to restore their credibility. Given major uncertainty about the future of the world economy, they face the unenviable task of either taking a wait-and-see approach until trends are clearer, or taking pre-emptive action to re-assert their credibility and prevent the worst if inflation remains persistent.
As the global economy cools, particularly driven by recent weak economic growth in China, these trade-offs will only become harder to make.
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Steve Schifferes does not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
This article was originally published on The Conversation. Read the original article.