Interest rates have been hiked at the fastest pace to decade high levels. Despite the pace and the steepness inflation persists — in every G7 economy and elsewhere — and is between two and five times the sacrosanct 2 per cent target. Questions about the credibility of central banks are effectively questions about the efficacy of monetary policy.
By Shankkar Aiyar | The Third Eye | Published: 28th May 2023 12:04 AM |
More than three decades back, in February 1990, New Zealand adopted and introduced the world to the idea of targeting inflation at 2 per cent. The logic of why 2 per cent is yet being debated. Typically it was wishful thinking following a bout of high inflation which evolved into a formal policy under Don Brash, the then Governor. In the following decades, the idea was inducted as policy orthodoxy by large economies and 2 per cent targeting was anointed as a commandment.
After nearly two decades of calm — thanks to globalisation and serendipity — global central bankers find themselves in a policy pickle and in violation of the commandment.
Inflation has defied theory and forecasts and seems to have turned ‘sentient’ — yes, that 17th-century phrase defining the ability to feel/perceive which tech cognates worry may afflict generative AI. And now it is baffling central bankers.
Data spells out the saga lucidly. In the past year, global central banks — after swearing allegiance to the inflation is transitory theory — have hiked interest rates at the fastest pace ever and to decade high levels. The US Federal Reserve has hiked interest rates 10 times taking its rate to 5-plus per cent. Inflation in the US continues to be sticky at 4.9 per cent, more than twice the target.
The Bank of England has hiked rates from 0.25 per cent to 4.5 per cent since February 2022. Consumer Price Inflation in the UK in April stood at 7.8 per cent or four times the target. The European Central Bank, though late to the party, has hiked rates six times to 3.25 per cent with more to follow. Inflation in the Euro Zone is up at 7 per cent, well above target.
To appreciate the distance between the objective of policy action and outcomes, one just has to review published data on global inflation. In May 2023, inflation in every one of the G-7 group of advanced economies is significantly higher than the target rate of 2 per cent. Barring Japan and China inflation in most of the economies is between twice and five times the 2 per cent target. India has done better at 4.7 per cent although CPI is well above the target band of between 2 and 4 per cent.
The reasons are under deliberation but as Don Brash once said, “History can be surprisingly confusing, even for those who were there.” The classical definition of inflation — too much money chasing too few goods — is still playing out. Advanced economies poured trillions in stimulus into the economies to prop aggregate demand when aggregate supply was hampered or locked down due to the pandemic. Fundamentally, it was not as much the intent which was questionable. It was the sequence and consequence of decisions that triggered the inflationary spiral.
Even as economies recovered from effects of the pandemic, the world was confronted by the war in Ukraine followed by spiralling costs of food and energy. Governments expended billions to subsidise the cost of consumption even as central banks were hiking rates to curb demand and inflation. Even the Reserve Bank of India contributed to the policy “avial” in May 2022 with the observation that it would be “accommodative while focusing on withdrawal of accommodation”.
This collapse of banks in the US and Europe earlier this year — caused by poor supervision and rational inattention on impact of rate hikes — forced central banks to open credit lines. The central banks were now confronted by a trilemma — inflation control, financial stability and employment.
The hope brigade argues that there is reason for the delay between action and effect. Milton Friedman in his 1960 tome ‘A Program for Monetary Stability’ stated that “monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable.” The argument has merit but there is also context to consider.
The architecture of the financial system has since changed. Digitalisation enables touch screen action to move billions within minutes. At a macro level the phenomenon of “shadow banking”, illuminated by Paul McCulley and the arrival of private credit muscling out banks in lending, challenge the regulatory framework and dilute transmission of monetary policy actions.
The perplexing question is whether the speed and steepness of rate hikes have any influence on inflation and if it does have an impact on the proverbial “lag”. On the face of it, in theory, the expectation is that the pace of rate hikes would/should reflect on consumption trends and asset price valuations but the score on that front is at best patchy.
The combination of tight labour markets and persistent inflation could well be scripting the obituary of the inverse relationship between inflation and unemployment stipulated by the Phillips Curve. Sure some of this is explained by geopolitics and the structural changes wrought by disruptions — demography, technology and climate change. But there is no mistaking that the questions about the credibility of central banks are effectively questions about the efficacy of the model of monetary policy.
As central banks prepare to raise rates again, the spectre of lower growth and higher for longer inflation looms large.
Meanwhile, the markets are turning, nay, spinning on the dime. Last month the put was on when the recession would kick in. The punt was on a pause in hikes followed by rate cuts sooner than later. This week the consensus call is more hikes.
Mystifyingly equities are up — probably riding the fear of missing out on AI-tagged stocks. Treasury yields are rising again, and growth is slowing but recession calls are muted. This could just be the new normal as central banks are flying blind.
Shankkar Aiyar, political economy analyst, is author of ‘Accidental India’, ‘Aadhaar: A Biometric History of India’s 12-Digit Revolution’ and ‘The Gated Republic –India’s Public Policy Failures and Private Solutions’.