When (and how) will the European central banks cut rates
When considering a possible interest rate cut, European central bank officials will take into account policy mistakes made in the past. Analysis by Robert Lind, Capital Group Economist
When considering a possible interest rate cut, European central bank officials will take into account policy mistakes made in the past.
Doves will remember the post-global financial crisis (CFG) period, when inflation was too low and monetary policy failed to offset the effects of weak underlying demand and overly tight fiscal policy. The hawks will instead go back to the early 1970s, when central banks collapsed the post-war monetary policy framework and supply/demand shocks destabilized inflation.
Markets are convinced that Europe's inflation problem is now resolved and that central banks will be able to cut key rates substantially over the course of the year. The consensus among economists is less strong, but continues to foresee a decline in the CPI (Consumer Price Index) towards the target in the Eurozone and in the United Kingdom, with a cut of around 100 basis points in the reference rate both by the Bank Central European Central Bank (ECB) and the Bank of England (BoE).
These relatively positive forecasts intrigue me, as economists and markets have significantly underestimated the extent and duration of the recent rise in inflation and tightening of monetary policy. In my opinion there are two problems to consider.
First, we don't have a reliable model for predicting inflation. The recent rally was the consequence of a complex combination of supply and demand factors following the pandemic and the Russia-Ukraine war, combined with the dramatic political responses to these shocks. While it is true that both primary and core data have fallen from their peaks, it is not yet clear whether they will stabilize at target levels.
Second, we do not know how central banks will react to news flows on economic activity and inflation, because the shocks of recent years have made predicting the “reaction functions” of the ECB and BoE much more complicated. It is unclear whether the response will be the same as in the post-CFG period.
Inevitably, in light of uncertainties, economists look to analogies to the past to guide the future – and central bank officials are also avid students of history. Perhaps the greatest difficulty is the lack of agreement on the most appropriate basis of comparison for the current macroeconomic environment. In the aftermath of the pandemic and with the Russia-Ukraine war underway (in addition to escalating tensions in the Middle East and possible new problems in US-China trade), is there an accurate model for predicting the future?
Doves and hawks
According to the ECB and BoE doves, the recent rise in inflation and interest rates will prove temporary and, once the effects of the pandemic and the energy shock fade, both will return to the historic lows of the post-financial crisis decade . According to this analysis, European economies will remain in a period of prolonged “secular stagnation”, in which aggregate demand remains anemic and macroeconomic policy excessively rigid.
In particular, European governments will be forced to tighten fiscal policy while demand from the private sector will remain weak due to concerns related to the future (debt sustainability, demographic trends, productivity, etc.) and central banks will not be able to keep interest rates real interest low enough to compensate. Chinese debt deflation will only aggravate Europe's internal difficulties.
The hawks, for their part, believe that recent shocks have profoundly changed the balance of risks facing the European economy. Massive supply shocks have spurred inflation, and – in a world characterized by geoeconomic fragmentation and a rapid energy transition – such shocks may become more frequent. Furthermore, the pandemic and the Russia-Ukraine war have turned the political picture upside down, promoting a more accommodative approach on the fiscal front and greater interventionism/protectionism in European labor and product markets.
For hawks, the need for further investment (in defense and energy transition) will support broader demand at a time of potentially limited supply, potentially triggering more persistent inflationary pressures.
For them the most appropriate historical analogy is not the post-CFG era but the early 1970s. In particular, central bank hawks cite policy mistakes made by their predecessors in response to the extreme economic turbulence of that period. Although I am not convinced that the economic chaos of those years will necessarily be repeated, I believe that the hawks are right to become aware of these mistakes and how they destabilized the main European economies.
It is worth remembering that the 1960s were a very positive period, characterized by solid growth and low inflation as economies recovered from the Second World War under the US Bretton Woods system. Although much emphasis is placed on the role of the two oil shocks (in 1973 and 1979) in increasing inflation, it is important to underline that some underlying tensions in the global economy had already emerged before that.
After a period of low inflation in the late 1960s, prices began to rise in 1970 and continued on an increasing trajectory in 1971 as fiscal policy eased in the US. At this stage Germany, the United Kingdom and the other major European economies were still part of the Bretton Woods system of fixed exchange rates (the pound had been devalued against the dollar in 1967). However, the Nixon administration's fiscal relief in the USA put the system in crisis. In particular, Germany began to no longer want to purchase US dollars to keep the exchange rate of the German mark fixed, fearing inflationary effects.
In May 1971 the German government decided to abandon the system, triggering significant turbulence. In August, Nixon closed the “gold window” by stating that the US would no longer convert dollars into gold at a fixed rate. This marked the abandonment of the Bretton Woods system with the consequent weakening of the dollar compared to the main European currencies.
This combination of shocks caused European economies to slow significantly even as inflation continued to rise. Initially, both the Bundesbank and the Bank of England decided to prioritize economic growth by cutting interest rates, assuming that slowing growth would help reduce inflation.
Instead, even as growth slowed, inflation continued to rise. Inevitably, central banks were forced to reverse course and at the end of 1972 began to aggressively tighten monetary policy to manage the recent rise in inflation. The oil shock at the end of 1973 only worsened the situation.
The lessons we can learn
This episode dates back more than 50 years. Without forgetting the important differences on the macroeconomic level, policymakers can draw some lessons from them.
Putting aside the political mistakes made in response to the oil shocks (especially in the UK) the 1971-72 period can perhaps teach us something more pertinent. Driven by the favorable environment of the 1960s, central banks believed they could prioritize economic growth over inflation because their models indicated there was a mechanistic link between lower growth and falling inflation.
But these models could not keep pace with the complexity of the supply-demand shocks that led to the abandonment of the Bretton Woods system in the early 1970s. In response to signs of declining growth and despite stubborn inflation, central banks eased monetary policy, but this only exacerbated the inflationary spiral and forced them to aggressively reverse course.
In the case of the Bundesbank, the sharp crackdown implemented in 1972-73 contributed to containing the surge in inflation even after the oil shock at the end of 1973. But in the United Kingdom (with the Treasury commanding the Bank of England) the political monetary policy remained too accommodating for too long, resulting in inflation becoming deeply entrenched in the economy. It took the trauma of the second oil crisis in 1979 and Thatcher's regime change in the early 1980s to bring inflation back under control.
Perhaps the most important lesson we can draw from the 1970s is that central banks should not rely too much on falling inflation forecasts that are the result of simplified models. While doves want to believe that inflation will quickly and sustainably return to target, hawks fear that a premature rate cut could reignite inflation and force a sharp policy reversal and even more aggressive tightening. In this case it is better to wait until we have clear evidence that inflation has returned steadily to target.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/consigli-banche-centrali-europee/ on Mon, 01 Apr 2024 05:44:12 +0000.