On May 4, the US Federal Reserve raised its benchmark interest rate by half a percentage point in an aggressive attempt to rein in soaring US annual inflation, which is currently at a record high. of four decades by 8.3%. And eurozone inflation hit a record 7.5% year-on-year in April, according to preliminary estimates.
These strong and significant price increases – accelerated by the war in Ukraine – raise the specter of stagflation and risk significantly eroding household purchasing power. Vulnerable low-income groups are likely to be hardest hit as they have limited access to financial markets, which prevents them from smoothing their consumption. Moreover, as prices rise more for the basic goods that dominate the consumption basket of low-income households, the rich-poor inflation gap – a phenomenon economists call “inflation inequality” – could still widen.
Just a few months ago, the price stability target was exceptionally low in the growth-inflation trade-off. Central banks, it was argued, should continue to focus on supporting post-pandemic economic recovery. But now the crucial question is whether monetary policy makers are doing enough to fight inflation. In the case of systemically important central banks, it is difficult to argue convincingly that they take into account the risks that have emerged.
For starters, major central bank forecast failures have allowed inflation to overshoot its 2% targets and potentially take root. Inflation was on an upward trend and exceeded official targets on both sides of the Atlantic in the first half of 2021, but Fed and European Central Bank (ECB) officials stubbornly insisted he acceleration in price growth was transitory.
This view contradicted their own monetary policy rules and was inconsistent with breakeven inflation rates – in the United States, the difference in yield between a nominal Treasury security and an inflation-protected Treasury security of the same maturity – relative to the market’s implicit expectations. The US five-year breakeven inflation rate is currently around 3% (down from a record high of 3.59% in March 2022), and the Fed’s long-term neutral rate is around 2.4%.
Well-calibrated pre-emptive strikes are often desirable to manage inflation. The risk of wrongly accepting the low inflation hypothesis and doing too little to prevent the threat from metastasizing far outweighs the risk of wrongly rejecting the null hypothesis of low inflation. This is especially true when the economy is overheated, as reversing inflationary trends becomes even more difficult once inflationary expectations become unanchored.
But that is precisely where the world is now. Some major central bankers – in their well-meaning attempts to support the fragile post-pandemic recovery – have decided not to anticipate inflation, or even react to current price pressures until they ease. prove persistent.
A succession of shocks in recent months has supported consumer price inflation. These include supply chain disruptions and bottlenecks, supply and demand imbalances, semiconductor shortages and rising commodity prices. Upward wage pressures also played a role, with the tightening labor market translating into higher prices, particularly in the United States.
While some of these shocks are potentially transitory consequences of the pandemic-induced slowdown, most have been caused by structural changes, notably the process of de-globalization triggered by the trade war between the United States and China. Similarly, supply chain disruptions – which would have added a full percentage point to underlying inflation in 2021 – were exacerbated by the pandemic but actually preceded it.
Moreover, the previous prolonged period of low inflation has fueled the mistaken belief that money creation is no longer inflationary. In 1993, then-Fed Chairman Alan Greenspan argued that the historical relationships between money and income, and between money and the price level, “have largely broken down, depriving the aggregates of much their usefulness as policy guides”.
But the current inflation overshoot may have validated Milton Friedman’s famous maxim: “Inflation is always and everywhere a monetary phenomenon. Continued money supply expansion has pushed ECB and Fed balance sheets to record highs in 2021, with M2 in the United States growing by $2.5 trillion last year. It was surely inflationary.
Jerome Powell, the current Fed Chairman, says the US central bank has the tools to keep inflation under control. The Fed has begun to deploy some of its arsenal, including scaling back asset purchases and raising interest rates, and may turn to other less commonly used tools to further shrink the money supply.
Unfortunately, the Fed must take these steps at a time when the risks of stagflation are rising. Global growth is rapidly decelerating and inflationary pressures are mounting due to the commodity price shock exacerbated by the Ukraine crisis.
The tools currently used by the main central banks will certainly help to contain inflation. But they will impose a high economic cost and could push the most vulnerable economies into recession. Targeting the neutral interest rate, at which monetary policy is neither restrictive nor expansionary, is difficult at the best of times. This is even trickier in a high inflation environment where trade-offs have to be made. A wrong decision now could easily spoil the nascent post-pandemic recovery.
If that happened, the costs would likely fall disproportionately on emerging market economies, and especially on low-income countries that are net importers of oil. Most of these countries were over-leveraged when they emerged from the pandemic-induced recession and now face higher service charges on their US dollar-denominated debt. Their currencies are also depreciating sharply at a time when rising current account deficits and rising imported inflation have already forced some countries to make difficult monetary and fiscal policy trade-offs.
Finding the right balance between economic expansion and price stability is more art than science, but systemically important central banks must strive to achieve it in order to support global growth. Of late, the pursuit of this goal has been made markedly more difficult by the increasing frequency of policy-induced economic crises of choice, from the Sino-American trade war to the globalization of the conflict in Ukraine.
“The central bank’s job is to worry,” said Alice Rivlin, vice chairman of the Fed in the late 1990s, and central bankers have a lot on their minds these days as the globalization accelerates the transmission of economic shocks generated by intensifying geopolitical tensions. This is all the more reason for them to avoid suboptimal policy choices that do not restore price stability or promote economic growth.
Hippolyte Fofack is Chief Economist and Research Director at the African Export-Import Bank.
Copyright : Project Syndicate