Meinung

The Stage Is Set for Another Monetary Policy Blunder

Rising inflation and a spike in two-year bond yields are putting central banks under pressure to raise their policy interest rates soon. That would be a mistake.

Stefan Gerlach
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With supercharged financial markets pushing up interest rates and breathing down their necks, central banks are starting to tighten monetary conditions. From Brazil to Russia, Norway to Australia, Singapore to the US, the mood music is changing as interest rates are raised, yield curve control is abandoned, the exchange rate is let to appreciate and tapering of bond purchases announced.

Almost exactly a decade after the ECB’s disastrous interest rate increases in 2011, the stage is set for what risks being another monetary policy blunder, but this time on a global scale.

Central banks are at the danger of making five miscalculations.

Don't confuse supply shortages with a demand boom

First, they may misjudge how quickly tighter monetary policy will impact inflation. Most central banks think that the peak effect is achieved in two or three years. At that stage the current burst of inflation may have subsided. Higher rates now may spell trouble later, at the ECB learned a decade ago.

Second, they may overestimate the role played by strong demand for goods and services in pushing up inflation and conclude that tighter monetary policy is required to rein in a surge in spending triggered by vaccinations and better news on the Covid front.

Of course, demand has risen, particularly in the US. But the main problem is that the economy’s supply side is taking time to reopen after being closed during Covid. With workers laid off, plants shut down and capacity curtailed, it takes time for the economy to return to full steam. One particular concern is that workers appear to think that this is a good time to quit and look for a new job.

Tighter monetary policy and higher interest rates will merely slow the adjustment. Confusing strong demand with weak supply does not make for good monetary policy.

Third, they may underestimate the sluggishness of inflation and conclude that the fact that it remains high although supply factors appear to be starting to moderate is evidence that tighter policy is necessary.

Like a super tanker, inflation is highly inertial. A sharp spike in energy prices feeds in gradually into higher prices for other goods and services. We see that in the US where median inflation rates are rising rapidly only since August after having been unaffected in the spring. Given how much inflation has risen, it is clear that it will take some time for it to return towards central banks’ 2% targets.

Fourth, central banks may underestimate the collective amount of tightening they are adopting. With inflation increasingly determined internationally, as a growing number of central banks opts for tighter policy, the contraction of global demand may be greater than they anticipate. The risk of such a miscalculation is magnified because the rise in inflation is so sharp and so strongly correlated across countries. On this occasion, there is no safety in numbers.

Fifth, it would be paradoxical after having worried for years that too low inflation would lower inflation expectations, if they raised rates as soon as inflation overshot the target. The level of prices in the US is still below the path they would have followed if the Fed had nailed inflation at 2% since Lehman Brothers collapsed in 2008.

Yes to tapering, but No to rate hikes

So, what should policy be? Tapering bond purchases, as the Fed is doing now, surely makes sense.

Asset purchases have highly asymmetric effects. When financial conditions are turbulent, they will stabilise markets. Having a very large player who does not trade for profit vacuuming up assets the private sector wishes to sell will have large effects on yields and risk spreads. But when the markets return to function normally, the situation is radically different. Bond purchases can indeed be stopped, and the bonds even sold cautiously, without causing rates to spike. A smaller balance sheet makes sense since it puts the central bank in a better position to return to quantitative easing if another severe shock hits.

And some emerging markets central banks whose currencies have depreciated sharply, thereby fuelling domestic inflation, surely want to prevent a spiral of depreciation and inflation by raising their interest rates moderately. With the Fed marginally tightening monetary conditions, they must do so too.

But developed markets central banks need to keep their cool and not overreact to a few months of unusually high inflation by raising interest rates. While not adjusting policy may come as a surprise to some financial markets players, that is a small price to pay for avoiding another monetary policy blunder.

Stefan Gerlach

Stefan Gerlach is Chief Economist at EFG Bank in Zurich and served as Deputy Governor of the Central Bank of Ireland in 2011-2015. Since earning a doctorate in Geneva in 1983, his career has bridged academia and central banking. He has been Professor of economics at the Goethe University in Frankfurt, an External Member of Monetary Policy Committee of the Bank of Mauritius, and Chief Economist at the Hong Kong Monetary Authority. Before joining BIS as a staff economist in 1992 he was an academic in the US.
Stefan Gerlach is Chief Economist at EFG Bank in Zurich and served as Deputy Governor of the Central Bank of Ireland in 2011-2015. Since earning a doctorate in Geneva in 1983, his career has bridged academia and central banking. He has been Professor of economics at the Goethe University in Frankfurt, an External Member of Monetary Policy Committee of the Bank of Mauritius, and Chief Economist at the Hong Kong Monetary Authority. Before joining BIS as a staff economist in 1992 he was an academic in the US.