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After a pandemic, a war in Europe and the worst global inflation in 40 years, central bankers are absolutely right to take a safety-first approach. The search for optimization of economic results has taken a back seat in favor of risk management. The big question of the summer is how policymakers can best set monetary policy with risk management in mind.
To understand economic data, central bankers must first clearly define the risks they manage. The only ones that matter are those that affect economic activity, inflation and people’s lives. Too often, central bankers say the worst outcome would be to enter a period of rising interest rates and then change their minds. This may be hard on their personal reputation, but comes with little cost to society. If they follow the path of being absolutely sure before making a decision to change rates, they will ensure that interest rate changes are late. This can result in real costs to be borne by others.
In the United States and Europe, the question is how far and how quickly to cut interest rates. Doing too much risks generating unsustainable demand, thereby preventing disinflation from succeeding. However, too much caution carries the risk of economies reverting to the pre-Covid world of deficient demand, below-target inflation and reliance on unorthodox monetary policy such as further quantitative easing. Ironically, hawkish central bankers should work to avoid this scenario, because it is the scenario they least want.
The interesting current phenomenon is that after a period of global shocks, risk management suggests that the time has come to decouple monetary policies on both sides of the Atlantic.
In the United States, domestic demand is strong. Although overall GDP figures for the first quarter disappointed with annualized growth of 1.6 percent, this does not reflect domestic spending. Final sales to domestic private buyers — a better measure of demand — grew at an annual rate of 3.1 percent, with much of that leaking out of the U.S. economy through imports. The savings rate is near historic lows.
In the Eurozone and other European economies like the UK, the situation could not be more different. While households are facing a much more severe income shock from soaring heating and electricity costs following Russia’s invasion of Ukraine, household consumption has remained weak. Savings rates remain high, creating the threat of insufficient demand. Although energy costs have now fallen, real levels of spending and investment have not increased accordingly.
It is wise to take the output gap assessments with a grain of salt, as they are very heavily revised, but these reveal a similar transatlantic story. The IMF estimates that the gap is positive in the United States, indicating continued inflationary pressure, while it is negative in the Eurozone and the United Kingdom.
Governments also separate the United States and Europe. Although deficits are lower and expected to decline in Europe, they are expected to remain high in the United States. Both of these may well be based on heroic assumptions, but it is clear that the fiscal impulse in the United States is stronger.
Labor market data is closer in the United States and Europe, but it does not change the situation in terms of risks. Low unemployment and low productivity growth are more likely to reflect labor hoarding in the face of weak demand than a persistent supply-side problem. There is scope for significant productivity improvement if European demand were stronger.
With such a divergent position between the US and European economies, the assessment of political risks should also be radically different.
In the United States, the position taken by the Federal Reserve this summer is that it must become more comfortable with disinflation before it can ease the pressure it is putting on the economic brakes. It’s reasonable. There are few signs of an economic slowdown and the latest inflation figures, while a relief, have provided little reassurance that price rises are stabilizing near the target of 2 percent from the central bank. Annual core CPI inflation was 3.6 percent in April, with most price increases taking place in the last six months rather than before.
If there is enough evidence that inflation is falling, the Fed can ease monetary policy with little risk, but there is also little danger in waiting until the fall.
On the other hand, Europe needs recovery measures. Inflation has been falling steadily and wage pressures in the eurozone are also forecast to ease. They are taking longer to fall in the UK, but the fall in headline inflation close to 2 per cent in April will make excessive wage demands harder to justify in the second half.
The main risk in Europe is that monetary policy remains too tight and compromises the necessary recovery of demand towards pre-pandemic trends. The continent’s central banks are expected to follow those of Sweden and Switzerland and launch a rate cut program. The ECB has indicated that it will take the first step in a few weeks. It would be wise to continue.
It is not ordered that interest rates move in sync across the world’s major advanced economies, even though global forces have kept them in tandem this century. The point of independent monetary policy is that policymakers make policy decisions without thinking about their own government or the Fed.
