Opinion – Martin Wolf: Central banks are right to act decisively

“Price stability is the responsibility of the Federal Reserve and underpins our economy. Without price stability, the economy works for no one. In particular, without price stability, we will not achieve a sustained period of strong job market conditions. that benefit everyone.” So Jay Powell, chairman of the Federal Reserve (the Fed, US central bank), opened his press conference after the meeting of the Federal Open Market Commission on November 2, at which it was decided to raise the federal funds rate by 0 .75 percentage points to 4%. Was he right. It is the State’s duty to ensure that its money has a predictable value. Central banks are entrusted with this task. Recently they have been failing a lot. It is a necessity and an obligation to correct this flaw.

Between September 2019 and September 2022, key consumer price levels that are relevant to people rose by 15.6% in the US, 14.1% in the UK and 13.3% in the eurozone. If central banks had hit their targets, those price levels would have risen by just over 6%.

There are good excuses for this failure, most notably the disruptions caused by Covid-19 and then Russia’s war in Ukraine. However, the result is not only due to supply shocks. In three years, until the second quarter of 2022, nominal demand grew by 21.4% in the US, 15.8% in the UK and 12.5% ​​in the eurozone. This equates to compound annual growth of 6.7% in the US, 5% in the UK and 4% in the eurozone. These demand growth rates are simply inconsistent with 2% inflation in these economies, especially the US and UK.

Not long ago, many feared that inflation would be too low for too long. In August 2020, the Fed duly announced a new “Statement on Long-Term Objectives and Monetary Policy Strategy”. In it, it stated that “after periods when inflation is persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time”.

It is hard to argue that the subsequent surplus inflation was “moderate”. Most importantly, she transformed history. In the US and UK, the increase in the price level over the last decade is equivalent to a compound annual increase of 2.5%. At the end of this decade, that level is about 6 percentage points higher in both countries than it would have been if the price target had been achieved. However, people are not arguing that symmetry now requires below-target inflation, perhaps by 1%, for six years. In the euro zone, on the other hand, the inflation of the last decade is now back to the 2% target.

The idea that one should correct the past was not sensible. But if people conclude that central banks will only compensate for past low inflation, not past high inflation, and that inflation shocks are also more likely than deflation shocks, they can reasonably conclude that average inflation will not be 2 %. This view will be reinforced by the fact that central banks adopt ultra-loose policies more enthusiastically than otherwise. In short, people will think they have a clear inflationary bias.

This is not just ancient history, far from it. It must shape what central banks do now. This is particularly true in the US, where the contribution of supposedly temporary increases in energy and food prices is less than elsewhere, and therefore domestic drivers of inflation are much more important.

This story strengthens the already strong case for getting back to the finish line sooner rather than later. Thus, the longer inflation remains high, the more the price level will be higher than it should be and the greater the accumulated losses for those who trust in the stability of the currency. This will stoke the anger. It will also make it more essential that losers can recoup their losses. This will make price-wage and price-price spirals more durable. Furthermore, the longer inflation remains above target, the more likely it is that inflation expectations will be fundamentally “de-anchored”. This would make the task of restoring credibility more difficult and the costs of doing so greater. The worst possibility of all would not be that disinflation proceeds too slowly, but that policymakers give up too quickly, making it necessary to do it all over again under even worse circumstances. This is also more likely if disinflation takes a long time.

Against this, it will be argued that there are risks of creating financial turmoil and an unnecessarily deep global recession, possibly even pushing economies into chronic Japanese-style deflation. That is indeed a danger. This is why the scale and duration of past fiscal and monetary support has been a mistake, especially in the US, as Harvard’s Lawrence Summers has long argued.

However, it’s hard to argue that a 4% interest rate is too tight in an economy with a core inflation rate of 6.3%. This is even truer of the Bank of England’s 3% and the European Central Bank’s 2%. If the US and global financial systems cannot survive even these low rates, they are in unforgivably bad shape.

Past policy mistakes interacted with a series of large shocks to generate high inflation. These errors are real and significant, however. It is noteworthy, for example, that comparable shocks to energy and food prices in the early 2000s did not generate inflation as high as it is in the US today. Aggregate demand has also been unsustainably strong, again particularly in the US. This must be corrected, firmly and quickly, to lay the groundwork for renewed growth. The pinch risks are real. But those of letting inflation consolidate are greater. As Macbeth says, if someone has a hard thing to do, “if it was over as soon as it was done, then it had better be done quickly.”

Translated by Luiz Roberto M. Gonçalves