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Central banks have the power to act decisively


“Price stability is the responsibility of the Federal Reserve and serves as the foundation of our economy. Without price stability, the economy wouldn’t work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit everyone.” Jay Powell, chairman of the Federal Reserve, opened Press Conference following the meeting of the Federal Open Market Committee on November 2, at which it was decided to raise the interest rate on federal funds by 0.75 percentage points to 4%. He was right. The state’s job is to ensure that its money has predictable value. Central banks are tasked with this task. Recently, they have failed miserably. It is a necessity and an obligation to remedy this failure.

From September 2019 to September 2022, the general consumer price level, i.e. the price relative to people, increased by 15.6% in the US, 14.1% in the UK and 13.3% in the region. European’s common currency. If central banks achieve their targets, these prices will rise by just over 6%.

There are many good reasons for this failure, notably the disruption caused by Covid-19 and subsequently Russia’s war with Ukraine. However, the results are not solely due to supply shocks. In the three years to the second quarter of 2022, nominal demand grew by 21.4% in the US, 15.8% in the UK and 12.5% ​​in the euro area. This equates to a compound annual growth rate of 6.7% in the US, 5% in the UK and 4% in the euro area. This rate of demand growth is simply not matched by 2% inflation in these economies, particularly in the US and UK.

Central bank policy interest rate line chart (%) shows Interest rates are still quite low by long term benchmark

Not long ago, many worried that inflation had been too low for too long. In August 2020, the Fed duly announced a “Statement of long-term objectives and monetary policy strategy“. In it, it states that “after periods of persistent inflation below 2%, accommodative monetary policy will likely aim to achieve moderate inflation above 2% for some time”. It is difficult to argue that excess inflation is then “moderate”. More importantly, it changed history. In the US and UK, the price increase over the past decade equates to a compound annual increase of 2.5%. By the end of the decade, that was about 6 percentage points higher in both countries than the target price had been achieved. However, people do not argue that the current symmetry requires inflation below target, perhaps at 1% in six years. In the euro area, by contrast, inflation over the past decade has now returned to its 2% target.

Line chart Nominal Domestic Demand (local currency, Q1 2000=100) shows that After Covid, nominal demand spiked, especially in the US

The idea that one should fix the past is irrational. But if people conclude that central banks will only compensate for low inflation in the past, not high inflation in the past, and inflation shocks are also more likely than other shocks. deflation, they can reasonably conclude that inflation will not average 2%. This view will be reinforced by the fact that central banks adopt hyper-easing policy more enthusiastically than vice versa. In short, people will think they have a clear inflationary bias.

This is not just ancient history, far from it. It should shape what central banks do now. This is especially true in the US, where the contribution of increases in food and energy prices is probably temporarily smaller than elsewhere and so domestic factors in inflation are much more important.

Line chart Consumer Price Index, January 2000=100 showing Price levels also spiked after Covid

This history reinforces the already strong case for getting back on target sooner rather than later. Thus, the longer inflation stays high, the higher the price level will be and thus the greater the cumulative loss for those who believe in the stability of the currency. This will cause anger. It will also make it all the more necessary for losers to be able to do so to cover their losses. That would make the price-wage and price-price spirals more sustainable. Moreover, the longer inflation remains above target, the more likely inflation expectations are to be fundamentally “anchored”. That will make the task of restoring reputation more difficult, and the cost of doing so will be greater. The worst-case scenario is not that inflation is done too slowly, but that policymakers give up too quickly, forced to do it all again in even worse situations. That would also be more likely if the deflationary process took too long.

Against this, one would argue that there are risks of creating unnecessary financial turmoil and deep global recessions, which could even push economies into economic deflation. Japanese style. This is a real danger. That is why the size and duration of financial and monetary support in the past is a mistake, especially in the United States, as Harvard’s Lawrence Summers has long argued.

However, it is hard to argue that a 4% rate is too tight in an economy with a core inflation rate of 6.3%. This is even more true for the Bank of England’s 3% and the European Central Bank’s 2%. If the United States and the global financial systems cannot survive even with these low interest rates, they are in unforgivably bad shape.

Past policy mistakes have interacted with a series of major shocks to produce high inflation. However, those mistakes are real and substantial. It is notable, for example, that similar shocks to food and energy prices in the early 2000s did not generate inflation as high as today in the United States. Aggregate demand has also increased unsustainably, especially in the US. This must be fixed firmly and quickly if the foundation for new growth is to be laid. The risk of tightening is real. But those who let inflation become entrenched were larger. As Macbeth puts it, if one has to do something difficult, it is “not so good / It was done quickly.”

martin.wolf@ft.com

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