12/09/2023 With central banks having scrambled
their way up the hill of interest rate hikes in a desperate bid to conquer the inflation
summit, the focus is now on their journey back down the other side. The big three of the
Fed, the ECB and the BOE are within touching distance of the peak. But inflation is not yet
at its magical target and more importantly it is becoming increasingly unclear how close it
will ever get to 2%. The central banks aren’t just stuck between the rock of missing their
target and the hard place of persistent inflation – if they get it wrong now then they lose
credibility forever. They could be accused of overdoing it and plunging the economy into
recession, or under-cooking the inflation pudding and leaving consumers mired in a cost of
living crisis. Or, even worse, both.
Missing a foothold or losing a handhold would leave
Lagarde, Powell, Bailey and Co plummeting off the mountain altogether. So they now have to
pick their steps very carefully. Lagarde just made a
speech
about the perils of central bank communication in the modern world,
pointing out that “
the average duration of attention on a screen has plummeted
from around 150 seconds in 2004 to a mere 47 seconds today
”. Even worse, she noted that “
more opinionated tweets are likely to reach more people. For
instance, research shows that ECB-related tweets with negative, stronger or more subjective
views are more likely to be retweeted, liked or replied to
”.
This isn’t just a rant against the evils of social media.
An absolutely key part of a central bank’s armoury is its ability to influence expectations.
Back in 2009 in the deflationary depths of the financial crisis it was the steadfast
commitment to reflate the economy that helped to restore optimistic animal spirits.
Conversely, in an inflationary economy it is important that the inflation doesn’t become
embedded into the system, creating self-reinforcing wage-price spirals, with the central
bank losing all control.
This is why there has been a strong pushback against
suggestions of increasing the inflation target itself. Once you accept that inflation won’t
get back to 2% but instead opt for 3%, then why not switch to 4% later? The inflationary
genie would be out of the bottle. Why would anyone ever believe a central bank ever again?
But there is no magic number for what constitutes the
“right” level of inflation. What suited the economy of the early 2000s could be too
restrictive for a more inefficient post-pandemic world that is still in the process of
reorganising itself. It might not be worth squeezing demand out of the economy just to meet
2% rather than 3%, leading to greater suffering for ever-poorer consumers and businesses.
You can see how the path to the summit is littered with
perils. Perhaps this is why Jerome Powell concluded his Jackson Hole
speech
with the
rather enigmatic “
we are navigating by the stars under cloudy skies
”. This doesn’t feel very helpful for those trading interest rates or
the currency.
Step forward Christine Lagarde with her
speech
at
Jackson Hole. In it, she built on a speech she gave in
April
where she
laid out a world that Chief Market Analyst for Finalto, Neil Wilson,
described
at the time as one where “
inflation is not going to rest around 2% easily, whatever
central banks try
”.
In Jackson Hole, Lagarde warned that the entire approach
to the economy might be wrong:
“In the pre-pandemic world, we typically thought of the
economy as advancing along a steadily expanding path of potential output, with fluctuations
mainly being driven by swings in private demand. But this may no longer be an appropriate
model. For a start, we are likely to experience more shocks emanating from the supply side
itself”.
This might sound like boring economics, and if we haven’t
already lost you after more than 47 seconds, stick with it… because this is a sea change in
how central banks operate. Lagarde argues that climate change, geopolitics and
digitalisation have changed the supply side of the economy, for example through bringing
supply chains onshore or to more “friendly” nations. She goes on to suggest that the
response to these shocks has changed. Workers are demanding more for their labour, whether
in terms of pay or other perks like working from home. Consumers have proven surprisingly
resilient to the ever-changing price of goods and services.
She goes on to explain that price/wage-setting behaviour
could be volatile for some time to come. Companies and workers can raise prices and wages
because others are doing the same and frequent price changes beget even more price changes.
She refers to a paper by Cavallo, Lippi and Miyahara, “
Inflation and misallocation in the New Keynesian models
” from the ECB’s Sintra conflab in June which contains this chart
showing how the frequency of price changes has accelerated since 2022 along with inflation:
It’s not
just that inflation might not get back to 2% but that it might swing wildly; 4% one year
then lurching into negative territory the next. The shocks are still working their way
through the system. How do you set interest rates in such a volatile world?
The central banks don’t know. You don’t know. But what we
all know is that getting to this summit of interest rates is going to be a wild and
difficult journey. No wonder that the BOE Chief Economist, Huw Pill, said he
preferred
the
lower flat top of Table Mountain to the dizzy heights of the Matterhorn. He wants to keep at
the peak of rates for as long as possible rather than ascend then decline with alacrity.
The ECB’s Isabel Schnabel has taken the alternative view.
In her latest
speech
she
warned “
We can also not commit to future actions, meaning we cannot
trade off a need for a further tightening of monetary policy today against a promise to hold
rates at a certain level for longer
”. In other
words, take the deep breath and get up to that summit or you might fall off the mountain
before you get there. It seems that the ECB has more hikes to come.
Helen Thomas
CEO of BlondeMoney
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