Major central banks have lost the plot when it comes to fulfilling their price-stability mandates. In April, 12-month US consumer price index (CPI) inflation was at 8.3%, down slightly from 8.5% in March, and the US Federal Reserve’s preferred inflation gauge, the core personal consumption expenditures price index (which excludes food and energy), was at 4.9%, down from 5.2% in March. But what the Fed should be doing is the opposite of what it actually is doing.
After increasing the target zone for the federal funds rate by 50 basis points to 0.75-1%, at its May meeting, the Federal Open Market Committee indicated that it will stick with 50-bps hikes at its June and July meetings. According to the May meeting minutes, all participants agreed that the US economy was very strong, the labor market was extremely tight, and inflation was well above target. Yet they decided that the FOMC “should expeditiously move the stance of monetary policy toward a neutral posture” (emphasis ours).
There are two problems with this. First, the Fed’s monetary-policy stance should be restrictive, not neutral. Instead, the FOMC merely noted “that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook.” Second, there is nothing expeditious about two additional 50-bps increases. The policy rate’s upper bound will still be only 2%, below the consensus estimate of a 2.5% neutral rate (the sum of a neutral real rate of 0.5% and the 2% inflation target).
The Fed’s balance-sheet tightening is also minimal. Starting in June, its holdings will shrink by $47.5 billion ($30 billion in Treasuries and $17.5 billion in agency debt and mortgage-backed securities) each month for three months, followed by an open-ended sequence of monthly $95 billion reductions ($60 billion in Treasuries and $35 billion in agency debt and MBSs).
That sounds like a lot of unwinding. But it is worth remembering that the Fed’s balance sheet had ballooned to nearly $9 trillion by the end of March 2021. At the current pace of reduction, returning the balance sheet to where it was in early March 2020 (about $4.2 trillion) will take more than four years. And it will take more than seven years to reach the level in early September 2008 ($900 billion), before the Fed erected its Great Wall of Liquidity around financial markets.
The Fed is not the only major central bank remaining behind the curve. The Bank of England’s policy rate is currently 1%. That is up from an all-time low of 0.1% in March 2020, but the BOE has limited its rate hikes to increments of 25 bps or less. At the May meeting of its Monetary Policy Committee, only three members (out of nine) voted for a 50-bps increase. In the MPC’s May projections, the market-implied bank rate reaches about 2.5% by mid-2023, before falling back to 2% in 2025.
This policy-rate projection appears way too low. The United Kingdom’s headline CPI inflation rose from 7% in March to 9% in April and is expected to peak at slightly over 10% later in 2022. The BOE projects that a significant slowdown in economic growth will bring inflation to its target in 2024; but while that outcome is certainly possible, we regard it as unlikely without significant additional monetary tightening.
The policy approach is similarly inexplicable in the eurozone, where headline CPI inflation was 8.1% in May, up from 7.4% in April. Nonetheless, the European Central Bank’s interest rate on its main refinancing operations remains zero, and its deposit rate is -0.5%. In an interview on May 25, ECB Chief Economist Philip R. Lane indicated that, following the end of net asset purchases in July, the MPC will set a benchmark pace with 25-bps hikes at the July and September meetings.
Meanwhile, the supposedly hawkish chief of Austria’s central bank, Robert Holzmann, has called for a 50-bps rate hike at the July meeting. Yet even if the ECB increases rates by 50 bps in July and again in September, the deposit rate will reach only 0.5%. Never mind that inflation will still be materially above target, and that, with the harmonized eurozone unemployment rate at 6.8% in April – its lowest level since July 1990 – the real economy will be close to overheating. The ECB’s dovishness exceeds even that of the Fed and the BOE.
All three central banks should be adopting a contractionary stance, setting policy rates significantly above the 2.5% neutral rate. A useful benchmark for the appropriate policy rate is the Taylor Rule, the original version of which recommends a policy rate equal to the neutral rate (2.5%), plus half the percentage difference between actual and potential real (inflation-adjusted) GDP, plus 1.5 times the difference between the actual and target inflation rates.
Suppose we conservatively assume that the output gap is zero in all three monetary-policy areas. For the eurozone, even if the actual (underlying) inflation rate is the 3.8% core rate rather than the headline rate, the benchmark policy rate would be 5.2%. And because it is hard to come up with actual underlying US and UK inflation rates below 4%, the benchmark policy rate for both the Fed and the BOE would not be less than 5.5%.
Far from being restrictive, the major central banks’ current stance remains expansionary, with policy rates well below the neutral level (and deeply negative in real terms). All three are therefore continuing to feed inflation.
At current levels, inflation is a severe economic, social, and political problem – one that especially hurts the poor and the financially unsophisticated. The more that longer-term inflation expectations become unanchored, the higher the cost of disinflation will be in terms of lost output and employment.
The inevitable and necessary economic slowdown should be engineered earlier rather than later. At each of the next two Fed and BOE meetings, policy rates should be raised by at least 100 bps, and the ECB should plan for three rate hikes of 100 bps or more. The ECB has not raised its policy rate for almost 11 years. Let us hope that it remembers how.
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