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After a pandemic, a war in Europe and the worst global inflation for 40 years, central bankers are fully justified in taking a safety-first approach. Seeking to optimise economic outcomes has taken a back seat in favour of managing risks. The big question for the summer is how officials can best set monetary policy with risk management front of mind.
To navigate the economic evidence, central bankers first need to be clear about which risks they are managing. 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 start a period of interest rate moves and then change their minds. This might be difficult for their personal reputation, but it carries few costs for society. If they follow the path of having to be absolutely sure before taking a decision to move rates, they will guarantee that interest rate moves are late. This can result in genuine costs for others to bear.
In the US and Europe the question is how far and fast to cut interest rates. Doing too much threatens to generate unsustainable demand, preventing a successful completion of disinflation. Too much caution, however, carries the danger that economies will revert to the pre-Covid world of deficient demand, below-target inflation and a reliance on unorthodox monetary policy such as further quantitative easing. Ironically, hawkish central bankers should strive hardest to avoid this because it is the scenario they least desire.
The interesting current phenomenon is that after a period of global shocks, risk management suggests the time is ripe for decoupling between monetary policy on both sides of the Atlantic.
In the US, domestic demand is strong. Although headline GDP figures for the first quarter disappointed with annualised growth of 1.6 per cent, this did not reflect domestic spending. Final sales to private domestic purchasers — a better measure of demand — rose at an annual rate of 3.1 per cent, with much of that leaking out of the US economy via imports. The savings rate is close to historic lows.
In the Eurozone and in other European economies such as the UK, the picture could not be more different. With households suffering a much more severe income shock from the explosion of heating and electricity costs after Russia’s invasion of Ukraine, household consumption has been weak. Savings rates remain elevated, generating the threat of deficient demand. Even though energy costs have now fallen, real levels of spending and investment have not picked up accordingly.
It’s wise to take assessments of output gaps with a pinch of salt because they are so heavily revised, but these show a similar transatlantic story. The IMF thinks the US has a positive gap, indicating continued inflationary pressure, while it is negative in the Eurozone and the UK.
Governments too are pushing the US and Europe apart. While deficits are lower and expected to decline in Europe, they are forecast to remain high in the US. Both of these might well be based on heroic assumptions, but it is clear that the fiscal impulse in the US is stronger.
Labour market data is closer in the US and Europe, but it does not change the picture on risks. Low unemployment and weak productivity growth are more likely to reflect labour hoarding in the face of weak demand than a persistent supply-side problem. There is the scope for significant productivity improvement if European demand was stronger.
With such a divergent position for US and European economies, the assessment of policy risks should also be radically different.
In the US, the Federal Reserve’s settled position this summer is that it needs to feel more comfortable about disinflation before it can ease the pressure it is applying to the economic brakes. This is sensible. There is little sign of an economic downturn and the latest inflation figures, while a relief, did not provide much reassurance that price rises were stabilising close to the central bank’s 2 per cent target. Core annual CPI inflation was 3.6 per cent in April, with most of the price rises occurring in the past six months rather than earlier.
If there is sufficient evidence that inflation is waning, the Fed can loosen monetary policy with few risks, but there is also little danger in holding off until the autumn.
By contrast, Europe needs stimulus. Inflation has declined steadily and according to forecasts, Eurozone wage pressures are also easing on cue. They are taking longer to fall in the UK, but the decline of headline inflation close to 2 per cent in April will ensure that excessive wage demands are more difficult to justify in the second half of the year.
The core risk in Europe is that monetary policy stays too tight and undermines a necessary recovery of demand towards the pre-pandemic trends. Central banks in the continent should follow those of Sweden and Switzerland and begin a programme of rate cuts. The ECB has indicated it will take the first step in a couple of weeks. It would be wise to continue.
It is not ordained that interest rates need to move in sync across the world’s leading advanced economies, though global forces have kept them in tandem this century. The point of independent monetary policy is that officials take decisions on policy without thinking about their own governments or the Fed.
