At their annual gathering in Jackson Hole, central bankers praised the decline in inflation. But do they deserve credit? In the rich world, annual price increases in the median country have fallen from a high of around 10% in early 2022 to less than 3% today. Surprisingly, this has been accomplished without major recessions. The Federal Reserve will most likely soon join central banks in Europe in decreasing interest rates, bond yields have fallen dramatically during the summer, and stock markets have brushed off a growth scare that struck at the beginning of August. The second quarter of 2024 saw America’s economy grow faster than expected before the covid-19 outbreak erupted.
Monetary tightening is designed to restrict growth, but in the 1980s, it only worked to reduce inflation after severe downturns. The seeming lack of damage today has revived a dangerous myth: that inflation would have disappeared on its own. According to Paul Krugman of the New York Times, Fed Chairman Jerome Powell used his Jackson Hole address to explain inflation “largely to transitory pandemic effects” revisiting an old storyline that central bankers abandoned in 2021.
That perspective is a misreading of both the economics and the speech. Mr. Powell stated that “high inflation was not transitory.” Papers presented at Jackson Hole demonstrated the crushing effect that rate hikes had on mortgage financing, as well as how the Fed feared losing credibility as inflation accelerated. Even forecasts who expected inflation to continue believed the Fed would not act, implying they had lost faith in central bankers’ commitment to price stability. The idea that rate increases would not occur risks aggravating inflation by lowering the real, inflation-adjusted rate of interest.
To reduce price growth, monetary policy does not need to produce a depression; it might just force the economy to grow more slowly than it would otherwise. This has been difficult to detect in America, where growth has been rapid, owing in part to an increase in immigration, and where a budget deficit of nearly 7% of GDP has offset higher rates. However, the labor market is cooling, as seen by a significant decline in job openings and a little increase in the unemployment rate. Meanwhile, Europe has taken so many blows, notably the conflict in Ukraine, that it is difficult to determine what caused what. But rate increases will have had a similar underlying effect.
Some contend that monetary tightening just restored an intangible feeling of legitimacy, and that the actual level of interest rates made little difference. However, as The Economist highlighted in 2022, rules of thumb predicted that American interest rates would need to climb to roughly today’s level. True, energy and food costs pushed headline inflation higher before falling. However, in the United States, the eurozone, and the United Kingdom, interest rate increases have been quite well correlated with increases in core inflation, which eliminates these volatile items.
Given the risk of future outbreaks, authorities must draw the correct lessons from the epidemic. Over time, several central banks have more or less met the global inflation targets established in the 1990s. However, this occurred in an era when supply shocks were uncommon and rich-world governments were generally fiscally prudent. Today, trade wars, the green transition, new pandemics, and massive public debt all threaten to cause inflationary shocks with which central banks will have to deal. It is therefore important to understand how they gained their current win over rising inflation. It was more than just a lucky break.
Source: Economist
