08.12.2022 11:49 PM
Inflation miss puts Fed and the ECB at a disadvantage

Economists are concerned about signals from the global market. Data shows behavior that contradicts expectations and probabilistic forecasts based on historical data and economic theory.

Inflation miss puts Fed and the ECB at a disadvantage

The reputations of central banks (honored just a decade ago for their part in saving the economy from the global financial crisis) are now on the line as they try to deal with inflation unseen in decades.

The generally accepted paradigm of central banks says that further rate hikes are necessary, even if, as Federal Reserve Chairman Jerome Powell has publicly stated, that it will mean "some pain". Higher cost of borrowing weighs on homeowners and squeezes company margins and this is the price of pandemic years' stimulus and subsidies.

It's already clear, next year their job will get tougher. The challenge is to find common ground as economic pain worsens. Powell has already faced criticism from both sides of the U.S. Congress; monetary policy in Europe has been challenged by politicians, including French President Emmanuel Macron, who has called on central banks to be "very careful".

As we know, Powell was anxious to avoid the mistake of central bankers in the 1970s by acting too slowly but also knew the credibility risk of surprising financial markets.

Before the prices data published in June, Fed officials had different opinions about how temporary the inflation spike would prove to be and what action was needed. The new numbers showed just how deeply rooted it was and that the small hikes made before that did not work.

Explaining the June hike, Powell told reporters afterwards that only once or twice in his decade-long Fed career had such game-changing data dropped so close to a rates decision. To those who say he was too slow to act, he admitted on several occasions with "hindsight" that he would have acted sooner.

Thomas Barkin, president of the Fed Richmond, had contacted Powell in June to support a larger interest rate hike than the one the Fed had all but promised to announce days later. He was alarmed that prices surged in May after falling slightly in April, which raised hopes that a recent uptick in inflation would be short-lived (he had maintained an aggressive stance last month). But he wasn't the only one calling Powell with warnings in June.

In the end, within days, the Fed announced a larger-than-expected 75 basis point interest rate hike, its biggest single step in nearly 30 years and what was to become part of its steepest rise in interest rates since the 1980s. This was the cue for central banks around the world to join a reversal of decades of cheap-money policies that will impact the economic fortunes of people around the world.

All is not what it seems

After years of tame inflation, Fed officials and other central bankers say they have faced a chain of disruptive events beyond their control ranging from the COVID-19 pandemic to the Ukraine war. This is sad to admit, but policymakers have acted as if the balance of 2018 has been achieved forever. Historically, though, there have been few instances in which events have evolved so quickly, moving from an era of weak price growth to a point where policymakers really had to go all out to bring inflation down.

In the United States, signs that inflation was taking on new proportions started to appear last year, from labor shortages to supply shortfalls across a growing array of goods and services. But the situation was not obvious to officials.

Richmond Fed's Barkin told Reuters that he came back from a June 2021 visit to Charleston, South Carolina, puzzled by anecdotal evidence that many people were not returning to work. Parents, he said he noticed, were struggling to find day care. Although, apparently, the employment problem has been shaking the labor markets since the quarantine.

Officials are now also beginning to admit that some of the projections were wrong.

David Altig, research manager at the Atlanta Fed, said recently that the view at the time that shortfalls in supply of goods and services would gradually ease was not being reflected in data and anecdotal evidence.

The Fed stuck to the view that the surge in inflation would subside as the pandemic-scarred economy returned to normal. "We continue to expect inflation to decline over the course of the year," Powell said in January, as the U.S. central bank continued to hold rates near to zero.

As a result, the central bank began raising rates in March, but its officials remained divided over how much it needed to raise them until the consumer prices data published in June ended the debate. In other words, it took central banks about half a year to allow for an inflation and now recession scenario, though independent economists, looking at the scale of the injections into the economy, were sounding the alarm back in 2021.

Now we are faced with this again: the central bank is giving conservative estimates of inflation, despite the fact that Russia has cut gas supplies to Europe in response to Western sanctions over its invasion of Ukraine.

Such firmness is alarming.

European Central Bank

The Fed's move to a more aggressive stance without spooking the markets helped forge a majority for tougher action at the Frankfurt-based European Central Bank (ECB).

By early summer, a group of policy hawks was pushing the ECB to commit to more than just a token 25 basis point rate hike and follow the path taken by the Fed.

On the other hand, there was concern that a rate hike could lead to an explosion in borrowing costs of indebted euro states - especially Italy - led in June to an agreement to help those countries with a so-called "Transmission Protection Instrument" (TPI) that would if needed be activated to prop up their debt. And now I ask myself, what is this, if not another infusion into the economy of weak countries?

There was a shared consensus that by addressing tail risks, TPI would also make it smoother to undertake a hiking cycle, as dovish policymakers insisted at the ECB's July meeting. But the hawks led by ECB board member Isabel Schnabel of Germany, Dutch central bank governor Klaas Knot and German Bundesbank chief Joachim Nagel insisted for a bigger move than the 0.25% point signaled to markets.

Those officials said the group, coordinating by phone and in-person meetings, sought to convince Lane they now had a majority inside the rate-setting Governing Council for such a decision. The ECB announced a 0.5% rate increase in July, followed by a 0.75% hike in September - its biggest move since 1999. In lock step with the Fed, a further 75-basis-point rise followed on Nov. 2.

Who will answer?

Although some economists say that peak inflation is just around the corner, central banks are still far from taming inflation. In the United States, it is more than three times the Fed's target of 2%, according to the central bank's preferred measure.

Last week, Powell said that the Fed was "slowing down" the pace of interest rate hikes. Financial markets now expect a 0.50% hike at the Fed's next meeting in mid-December, the same increment that the ECB will announce a day later.

Nevertheless, both Powell and his ECB colleague Christine Lagarde insist that rate hikes will continue. At the same time, the concern among some central bankers is that politicians will respond by raising public spending and so aggravate the inflation pressure that their rate-hike cure is intended to heal.

Last week, Lagarde warned that such spending could push up demand and cause it to fall further behind supply, and thus "might force monetary policy to tighten more than would otherwise be necessary," noting signs that this was already happening in the euro area.

In fact, demand does not bother economists. It has been declining since the beginning of inflation, showing isolated peaks in the beginning, associated with the creation of a cushion. But any infusion would certainly allow more money to be spent by consumers, which means demand would get a boost.

Former Bank of England official Charles Goodhart believes that record public debt levels could at some point pose such a risk to financial stability that central banks may have to abandon policy tightening halfway through. There has been talk of this since January of this year. But few can offer something as effective as a rate hike.

In contrast to Goodhart, Carstens of the BIS said that he is sure that central banks will remain firm in the fight against inflation. But, he said, the past two years have shown how important it was for economic policy to be coordinated across the board and that the old idea of central bankers as "policy responders of first resort" was outdated.

In other words, while we observe that while many central banks are raising interest rates, governments are destroying the effect of this measure by providing subsidies to household producers, for example in the field of energy. A very striking example of this is Brazil's regulatory policy. I think this is what makes the rise in inflation unstable, and gives false hope to markets about the point of peak inflation and future recession.

Of course, one cannot ignore the fact that, for example, the energy risks associated with falling demand have been shifted almost entirely to Russia. This will allow other oil and gas producers to keep the price ceiling and not fall in supply volumes. However, inflation is more global than just the fuel component. Especially against the backdrop of China's harsh quarantines.

And while Beijing's plans for quarantines are now looming, if Xi Jinping's government achieves its goals, relocating multinational companies' production to other areas will cost a lot, and take time. It will also drive up prices. China's closure factor alone could keep inflation above the 2% target even in 2024 and for a couple more years to come before the global economy refocuses on new regions. The conflict between Russia and Ukraine, on the other hand, is causing unnecessary budget expenditures for both the U.S. and the EU. And that means that servicing foreign debt will become more expensive.

And now I wonder, will we see this peak in inflation? Or will it rather turn into a prolonged plateau, albeit not double-digit, but just as devastating because of the time factor? At least as we have seen so far, both the Fed and the ECB have missed their forecasts. Can we rely on them now?

Egor Danilov,
Analytical expert of InstaForex
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