At what point should central banks stop monetary tightening?

Naïve inflation forecasts had a better record than inflation forecasts from sophisticated models. Photo: Bloomberg
Naïve inflation forecasts had a better record than inflation forecasts from sophisticated models. Photo: Bloomberg


When central banks stop tightening will depend on a tough-to-estimate neutral rate that can keep economies on an even keel

Most economists in central banks, governments, the financial sector and academia failed to anticipate the sharp rise in inflation this year. It can be said in their defence that even the most sophisticated forecasters could not have predicted the Russian invasion of Ukraine. That would have required a crystal ball rather than a forecasting model. Inflation in many developed economies is now running at twice the rate forecast even six months ago.

Predicting inflation is difficult even in the best of times. Andrew Atkeson and Lee E. Ohanian surprised many when they showed in 2001 that naïve inflation forecasts had a better record than inflation forecasts from sophisticated models based on the Phillips Curve, which famously maps the tricky choice between inflation and economic activity (‘Are Phillips Curves Useful for Forecasting Inflation?’, Federal Reserve Bank of Minneapolis, 2001). In other words, someone would be better off simply assuming that inflation this year will be the same as in the previous year rather than depending on statistical models based on a battery of economic variables. However, such naïve inflation forecasts would obviously work better when the cost of living is relatively stable over the years, like a calm sea. The record would look different when the inflation trajectory suddenly changes, as it did this year. Just banking on the hope that inflation will continue on its old path will not do the trick in times such as these.

The inflatin growth challenge
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The inflatin growth challenge

The accompanying table shows data from 15 large countries, not necessarily the biggest economies in the world, but including most of them. There are two sets of numbers. The first shows how inflation in 2022 in these countries will differ from inflation in 2019, the last year before the pandemic struck. Almost all countries will see their general price level increase far faster than it did in 2019.

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The second set of numbers compares what gross domestic product (GDP) at constant prices in each country would have been if their economy had continued on its pre-pandemic path versus the actual expected GDP at the end of this year. The GDP data is in local currency rather than US dollars to prevent the movement of exchange rates from muddying the analysis.

The countries can then be divided into four groups. First, those countries where GDP has caught up with the trend while inflation has risen sharply. Second, those where GDP is either close to or above trend but inflation is still near the pre-pandemic level. Third, those where GDP is still below trend but inflation has risen sharply. Fourth, those where GDP is still below trend but inflation is still not too far from the pre-pandemic level.

Indian GDP has not yet caught up with the trend, or what it would have been in 2022 if there had been no pandemic, but inflation has not spun out of control either, though it is still much higher than the central point of the formal inflation target range that the Reserve Bank of India (RBI) works with.

Despite the nuanced situation in each country, a quick look at the data shows that there is good reason why most central banks are now more concerned about controlling inflation than stimulating economic activity. The pace of monetary tightening needed from here on depends on a combination of two trajectories—inflation and output. There is a big question embedded in this: At what point should central bankers be satisfied enough to stop monetary tightening?

A lot depends on their assessment of the neutral or natural rate of interest, which can broadly be understood as that level of the real interest rate at which an economy grows at its potential while inflation is near the inflation target, preferably over the business cycle rather than in a single year or quarter. Some of the recent monetary policy debates in India have focused on the appropriate natural rate of interest.

Background: The committee headed by former RBI governor Urjit Patel, which laid the intellectual groundwork for the shift to flexible inflation targeting in India, had some important suggestions on the policy rule for the Indian central bank to follow. It noted that a simple policy rule such as a level of the real policy rate—or how far the repo rate is above or below the inflation rate—is better suited for India than other options that are more difficult to communicate. The general principle is that the real policy rate should be positive when inflation is above target, though the committee was careful to add that the decision also depended on the output gap and financial stability.

The neutral interest rate thus defined is not set in stone, but depends on the state of the business cycle. In the jargon of economics, it is time-variant. Economists at RBI had estimated in 2015 that the neutral rate of interest was between 1.6% and 1.8%. More recent estimates from the country’s central bank put it at between 0.8% and 1% in the third quarter of 2021-22. Most would agree that the real interest rate needed to keep the economy on an even keel has come down in recent years, though that can change as economic circumstances change.

Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.

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