Central banks weigh economic growth against inflation control

Despite some victories in the U.S. and the eurozone, policymakers now face the challenge of maintaining economic growth while restraining inflation.

In a nutshell

• • • • • • • • • • Inflation rates have decreased but remain problematic
                  • Central banks want to maintain growth while controlling inflation
                  • Interest rates and inflation expectations will shape future monetary policy

The war on inflation is not over, but judging by the data, some battles have been won. In August, the annual rate of inflation was 2.5 percent in the United States and 2.2 percent in the eurozone. Core inflation, which excludes energy and food, was 3.2 percent and 2.8 percent in these areas respectively. Money printing has been brought under control and the proportional rise in prices has slowed since June 2022 in the U.S. and October 2022 in the eurozone. Central bankers have always claimed that their goal is low inflation (about 2 percent), rather than stable purchasing power for the dollar and euro. By that metric, success is in sight.

Moreover, the public is calm, expecting slowdowns in the price indexes before long. Most people are not aware that inflation has major redistributive effects, and that the low- and middle-income earners usually get hit. But workers realize that inflation ends up eroding their purchasing power; homeowners worry when rising nominal interest rates make their mortgages heavier; and pensioners know that under high inflation the real return on safe securities such as bonds drops to zero or turns negative.

That said, big government and part of the business world have other priorities and possibly other plans. The 2 percent inflation target may not be the true target.

Inflation: Causes and consequences

Red lines for monetary expansion

Governments traditionally like generous monetary policies in general, and money printing in particular. They believe that by increasing the money supply – for example, by manipulating interest rates – they can create economic growth, while newly printed money can be used to buy treasury bills, thus allowing policymakers to finance public expenditure “for free,” without resorting to taxation or private savings.

But things have changed. After the major blunders of the past couple of decades, the “print what it takes” mantra has now been replaced by the “prudent monetary policy” slogan, where “prudent” means that monetary policy should be as generous as possible without unleashing a rate of inflation judged intolerable to the electorate. This shift raises two big questions: What delineates the red line for monetary expansion, and how can policymakers ensure they do not cross this line?

Both the U.S. and several European Union governments are currently in need of generous monetary policies and inflation support. This demand is not a recent development; as mentioned above, governments require additional revenue to manage public deficits. They also benefit from low interest rates that reduce the cost of borrowing and debt-servicing and boost private investment and debt-financed households’ consumption. Governments also need inflation to rein in some key expenditure items in real terms (such as state pensions), reduce public indebtedness in real terms, and possibly enhance debt sustainability (the debt-to-GDP ratio).

There is no objective way to determine the point at which monetary profligacy becomes alarming, but it takes time – at least two years – before monetary policy fully translates into consumer price inflation. People’s unease depends on their short-term debt-servicing (interest rates are often linked to inflation) and on how much they depend on capital income (including pensions). Of course, the latter effect is larger in countries with older populations. In this light, government action can take three different paths, as described in corresponding scenarios.

Scenarios

Most likely: Gradual easing

The most likely option involves central banks cautiously lowering interest rates to sustain economic growth, and keeping them low unless inflation resurges. The target could be set at around 3 percent for the U.S. federal fund’s rate and 2 percent for the European Central Bank deposit facility rate. Such a move would meet with the approval of the political and business spheres, and there would likely be economists ready to provide theoretical justifications for this course of action. After all, this trick worked from the late 1990s until 2021, and some may think it could work again. Central banks, aware of the short timeframes that characterize political cycles, would bear a minimal cost if the gamble backfired and the threshold were reached earlier than expected. 

Less likely: Defining boundaries 

A second, less likely option would be for policymakers to seek to determine where the threshold lies for maintaining tolerable inflation and acceptable interest rates. On this path, policymakers would note that American households and voters are seriously concerned about capital incomes (private pension plans play a larger role in the U.S. than in Europe) and private debt, which amounts to some $140,000 per household. In comparison, average household debt is about $42,000 in Italy, $56,000 in Germany and $70,000 in France. 

During the 2010-2020 period, nominal interest rates on personal loans in the U.S. were close to 10 percent, and Americans have historically reacted nervously as soon as rates started rising above that level (they are currently 12 percent). They also focus on nominal rates, as incomes tend to lag behind inflation. On the other hand, capital-income earners expect their quasi risk-free assets to yield at least 1 or 2 percentage points in real terms. Failure to meet this target encourages them to take chances and move their wealth to the stock market. This puts pressure on the bond market and causes interest rates to inch higher.

The authorities are faced with a dilemma: To defuse alarm, they must ensure that nominal interest rates drop a couple of points. At the same time, they have to keep inflation below 3 percent, so that the real return on safe securities is consistent with people’s expectations. To achieve this, central banks must bring money printing almost to a halt in the hope of killing inflation expectations, drive interest rates down to encourage the banking sector to expand their lending activity (making the money supply rise), but also be ready to slam on the brakes should price inflation rise above 3 percent. This is a tricky path; the record of experimenting with fine tuning is poor, and economic growth is required to ensure that a modest rise in the money supply does not translate into excessive price inflation. But it could work.

The above applies to the U.S., but the line of reasoning is similar for Europe. However, the European Central Bank may have an easier job: European households are, as noted, less indebted than their American counterparts, and therefore less sensitive to interest rates. Moreover, price inflation is currently lower than in the U.S. and more or less under control. All in all, European authorities face laxer threshold constraints, and holding a steady course would not be overly problematic. Europe’s major problem is the EU’s relentless ambition to engage in grand and very expensive, presumably bond-financed projects, accompanied by growth-killing regulatory straitjackets. That is a recipe for failure. 

Somewhat less likely: Abandoning prudence

The third and somewhat less likely scenario entails a situation in which central bankers on both sides of the Atlantic are put under pressure to depart from a prudent policy path and engage in money printing and/or aggressively cut interest rates to solve public finance problems. While this approach may offer a temporary respite, it risks plunging Western economies into a monetary crisis, with geopolitical ramifications potentially favoring China and most low-income, highly indebted countries.

China, for one, would eagerly exploit any dollar and euro crises and renew its efforts to make the yuan a widely accepted reserve currency. Meanwhile, the low-income, highly indebted countries, being burdened by heavy debt servicing costs – high interest rates on loans outstanding and repayment of principal – see two possible outcomes: the fall of the dollar and the euro, or default on their foreign debts. Nonetheless, these geopolitical consequences would probably pale in comparison with the domestic dramas that a monetary meltdown would trigger in Western countries. 

The most probable scenario will not center around the official 2 percent inflation target. Instead, policymakers are likely to shift their focus toward the constraints imposed by acceptable nominal interest rates and price inflation. Although there is some flexibility in these in the short term, it is clear that in the long run interest rates cannot be significantly lowered from current levels without risking rampant money supply growth. A crucial factor will be the ability of central bankers to disregard persistent calls for continued public spending and increased debt – both domestically in the U.S. and Europe, and further afield, from low-income countries.

Author: Enrico Colombatto professor of economics in Italy

Source

Central banks weigh economic growth against inflation control