Inflation or recession: a dilemma that central banks can no longer solve
Monetary policy is arid and technical terrain. Paradoxically, it is also hostage to what John Maynard Keynes called “animal spirits”: exalted moods, spontaneous intuitions in the markets, the “credibility” that a central banker manages to convey in a certain press conference, or even confrontations between birds. The “hawks” are in favor of a tough monetary policy to contain inflation, even if it damages the economic outlook; the “doves” advocate a more gradual adjustment, lest the cure — an economic downturn — turn out to be worse than the disease.
Inflation is back and the aviary is restless. The hawks point to the 1970s, when the US Federal Reserve (Fed) made sharp increases in interest rates in response to the oil shocks and stagflation . Blockchain development company The rate hike recently announced by the European Central Bank (ECB) — the first in more than a decade, which comes after the end of its interventions in the European public debt markets — would come late and badly, because inflation has been going on for almost a year growing. The Fed, which has just announced the biggest rate hikein almost three decades, it would have better anticipated the business cycle. The pigeons, however, hear echoes from 2008–2011. At that time the ECB, in order to head off a temporary bout of inflation, raised rates precipitously, deepening an economic recession. The current adjustment could be premature and cause unnecessary damage: just look at the — increasingly plausible — probability of a recession in the US next year, or the emergency meeting called yesterday by the ECB to prevent premiums from skyrocketing of risk in the south of the EU.
In which of these two worlds do we find ourselves? Today inflation is deeper and more sustained than in 2008–2011, but it is not reaching the levels of the 1970s. The key issue is that, as on both occasions, the role of central banks is transforming at a fast pace. And that transformation reduces the tools available to solve macroeconomic problems.
To understand the problem it is useful to examine where inflation comes from. Every day it seems less plausible that it is, as Milton Friedman proclaimed, “always and everywhere a monetary phenomenon.” The crises of 2008 and 2020 were fought by flooding the financial markets with money. But until 2021 the problem in the euro zone was not high inflation, but too low . The origin of this secular stagnation , as the economist Larry Summers called it, lay in processes outside monetary policy: for example, the deflationary impact of technology or the incorporation of China into the world economy.
If inflation is not just a monetary phenomenon, raising interest rates may be a limited instrument to tackle it. This is indicated by a recent study by David Ratner and Jae Sim. The authors study the stagflation of the 1970s based on the work of Michal Kalecki , a macroeconomist who understood inflation as a redistributive phenomenon . Kalecki argued that, in a world with strong unions, workers would be able to obtain wage increases in excess of increases in their labor productivity. That would end up unleashing inflation and, with it, a reaction from large companies, which would demand orthodox economic policies: interest rate hikes and prioritizing price stability over full employment.
The report is surprising because it is published by the Fed’s own research service. The US central bank would be admitting that it lacks essential instruments to maintain price stability. The ability of central banks to carry out the mission entrusted to them from the 1970s would thus be called into question.
If inflation is more linked to labor unrest than to monetary policy, its return could reflect a reaffirmation of the world of work , which has been weakening for decades. However, and despite phenomena such as the “Great Renunciation” in the US or the growing unionization in companies such as Amazon or Starbucks, there is no clear trend in that direction. Current inflation responds to other factors: imbalances between international supply and demand after the confinements; rising food and energy prices, exacerbated by the war in Ukraine; and, as ECB economist Isabel Schnabel points out, growing corporate profit margins. But the original problem persists. Rate policy is a clumsy and crude instrument at this juncture. Raising them abruptly is not likely to curb inflation, but the decision is likely to produce a global economic recession.
All this leads us to an uncomfortable paradox: tightening monetary policy seems as inescapable as it is inopportune. Inescapable because it is not feasible to maintain negative interest rates when inflation in the euro zone is four times higher than the mandates of the ECB and the Fed. And because extraordinary liquidity programs have already greatly increased economic inequality, by disproportionately inflating markets stock market It should also be remembered that these monetary policies were always a technocratic patch in the face of the political inability –of the different European governments, or of the US presidency and legislature– to coordinate a supportive and effective response to the 2008 crisis.
Still, raising rates now carries huge risks. It will hamper the financing of households, businesses and the public sector. If the ECB is not credible in its support program for countries like Spain and Italy, it risks causing financial fragmentation in the EU. Blockchain Development services The rises in the US, on the other hand, could generate a debt crisis in emerging economies, hindering their access to financing and direct investment. All this will aggravate an increasingly fragile post-Covid recovery. While there is never an ideal time to tighten monetary policy, the current environment is particularly inopportune.
In the past, central bankers established themselves as unquestioned authorities. Everything indicates that this decade will expose the limits of his power.
