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The course of disinflation never runs smoothly. Late last year, futures markets had forecast six U.S. interest rate cuts in 2024. My own expectations had also become quite optimistic. Yet after three straight quarters of stubbornly high inflation, US Federal Reserve Chairman Jay Powell warns that it will likely take “longer than expected” for inflation to return to the 2% target. the central bank and justifies a reduction in interest rates. Market expectations for rate cuts have been transformed. Some suggest they will be delayed until December, in part to avoid budget cuts before November’s presidential elections. However, no similar thinking has emerged in the eurozone: the first reduction is still expected to be made in June.
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Lessons come from this story. The first is the uncertainty inherent in any disinflationary process. Another reason is the difficulty of reading the data: in this case, part of the explanation for the recent robust “core” consumer price inflation figures is “homeowners’ equivalent rent.” However, this is only an imputed figure. It is not yet clear that a fundamental change has occurred in the American disinflationary process. A final lesson is that, although there are clearly common factors in the inflationary process across the Atlantic, the economies of the United States and the Eurozone have been different: the former is much more dynamic.
The IMF’s latest World Economic Outlook provides an illuminating quantitative comparison of inflationary processes in the United States and the Eurozone, derived from three-month annualized average inflation. Labor market tensions have played a much larger role in inflation in the United States than in the Eurozone and, importantly, this continues to be the case. At the same time, the transmission effects of rising world prices, particularly energy prices, have been much greater in the euro area. This made Eurozone inflation more credible “temporary” than that of the United States. This has implications for monetary policy. (See charts.)
Two other facts help elucidate what happened. One concerns nominal domestic demand. In both the US and EU, aggregate nominal demand fell well below trend growth levels from 2000 to 2023 during the pandemic. In the second quarter of 2020, nominal demand was up to 12% below trend in the United States and 14% below trend in the Eurozone. In the fourth quarter of 2023, on the other hand, it was 8 percent. above the trend in the United States and 9 percent above the trend in the euro area (where trend growth has also been lower). This explosive growth in demand in these two crucial economies must have caused supply shocks while only accommodating them. But that’s in the past. In the year to the fourth quarter of 2023, nominal demand grew by only 5% in the United States and 4% in the Eurozone. The first is still a bit too high, but it’s still close to what’s needed.
A second relevant fact concerns money. I remain of the opinion that these quantities should not be ignored when assessing monetary conditions. The pandemic has not only led to a considerable increase in budget deficits, but also an explosive growth in the broader money supply. In the second quarter of 2020, for example, the US M2-to-GDP ratio was 28 percent higher than the linear trend from 1995 to 2019. By the fourth quarter of 2023, it had returned to just 1 percent higher. For the eurozone, these ratios were 19 percent and minus 7 percent, respectively. These figures show a huge monetary boom and bust. In the future, disinflationary pressures could prove excessive.
So, what should we do now? In answering this question, leading central bankers need to remember four crucial points.
The first is that ending up with inflation well below target is, as we have now learned, pretty bad, because it risks making monetary policy ineffective. Central banks should assume that the consequences of too restrictive a policy could be almost as serious as those of too loose a policy. Furthermore, it is not insignificant that the former can be particularly harmful to vulnerable debtors around the world.
A second point is that uncertainty cuts both ways. It is obviously true that demand and therefore inflation could prove too high, particularly in the United States. But it could also turn out to be too weak. Policies that eliminate the mere possibility of the former could make the latter a certainty. So even if the goal is rightly to bring inflation to its target level, it makes no sense to pay any price to achieve that goal: its value is not infinite.
A third point is that there are problems with the determination to eliminate the very possibility of having to change course. If we assume that the first cut in interest rates must be followed by many other cuts in the same direction, the degree of certainty needed before starting will be too great. The price of waiting until it is certain will likely be the price of waiting too long.
The final point is that it actually makes sense to depend on data. But new data only matters if it significantly affects predictions of the future. What matters is not what is happening now, but what will happen in the months and even years to come as past policies ripple through the system. New information must be viewed through this lens. There is good reason to assume that the recent inflation news in the United States is not very significant. Unless the Fed is reasonably convinced that this is the case, it should ignore it.
Now is where the decisions start to get really tricky. Two years ago, it was clear that monetary policy needed to be tightened: the risk of entering a world of high inflation was too high. But it is now clear that the ECB should soon start easing its monetary policy. The underlying situation in the United States is more balanced. But the Fed also cannot wait indefinitely.
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