Lessons need to be drawn from wars waged by central banks against inflation
Summary
- How long it took to restore relative price stability defied text-book assumptions of the process, while the monetary tool deployed for that purpose by the US Federal Reserve and other central banks should offer the heterodox some food for thought.
The US Federal Reserve began a new cycle of interest rate cuts last week. The 12 members of the Federal Open Market Committee lowered the key lending rate by a hefty 50 basis points.
The rate-setting group expects four more cuts in 2025 and a further two in 2026, which means that the US policy rate could be settling at three percentage points below the current level, assuming we see more normal rate cuts of 25 basis points each from now on.
At the end of 2026, the US Fed Funds Rate is likely to be a slim 25 basis points higher than its level before the pandemic disrupted the global economy in the early months of 2020.
In that case, the easing cycle will be far slower than the tightening cycle, which reflects the underlying reality that inflation accelerations tend to take place faster than the subsequent disinflation.
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Nick Timiraos reported in the Wall Street Journal after the rate decision that the US central bank has had six previous rate-cutting cycles in the past three decades. Three of them began with a modest reduction of 25 basis points.
Three others began with 50 basis points sliced off the key policy rate with one stroke. The deeper cutting actions were timed with extraordinary challenges—the bursting of the tech bubble in January 2001, the implosion of the subprime credit market in August 2007 and the beginning of the pandemic in March 2020.
The size of the recent cut in one of the pivotal rates in US financial markets is thus unusual. It comes in the wake of expectations of a soft landing in that country, rather than the beginning of a severe recession, as was the case in 2001, 2007 and 2020.
The official statement from the US Fed says that “the unemployment rate has moved up but remains low" while “inflation remains somewhat elevated" despite trending down.
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One explanation for such a drastic rate reduction is that it is a response to the intensity of the post-pandemic tightening cycle that saw US interest rates rise sharply, to their highest level in 20 years, in response to inflation not seen there since the early 1980s.
The US Fed funds rate was pushed up by 5.25 percentage points within 16 months, through 11 rate hikes, from 2022 to 2023. It is worth remembering that the “higher for longer" narrative was quite widespread as recently as May. So the question worth asking right now is this: Has the wave of inflation across the world decisively receded?
In 2021, all the ten major economies represented in the alongside table had peak inflation that was above their formal targets. The reasons are well known, especially the combination of a demand stimulus in the midst of a supply squeeze. Price levels had threatened to get out of control, more so in the US, UK and Europe.
The situation is quite different now. Only a few countries such as Japan and Russia have inflation levels that are far higher than the targets their central banks have been given. A few countries have inflation well below target.
China is one important example. It is worth asking whether it will once again be exporting deflationary impulses to the rest of the world, as it did in the first decade of this century, a result of its chronic overcapacity in several key sectors—or what is now described as the second China shock.
Inflation has generally normalized, but not every central bank seems confident that the battle is over. That shows in the different central bank actions over the past few months. The US Fed, the European Central Bank and very recently the Indonesian one have reduced the cost of money in their respective economies.
Russia, Japan and Brazil have moved the other way. Their most recent monetary policy action has been to increase interest rates. All three have inflation well above target. The third group is countries whose monetary authorities have still kept their fingers on the pause button—the UK, Korea, China and India.
Such a divergence is not unusual. It is generally the case that it is easier to coordinate monetary policy globally during a crisis than in relatively normal times. Interests are better aligned in a crisis. Also, entry can be an easier decision than exit when it comes to monetary policy.
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A former Reserve Bank of India (RBI) governor had once compared this dilemma to the chakravyuha that trapped a young Abhimanyu in the Mahabharata.
There are two important takeaways from the recent inflation-disinflation cycle. First, inflationary pressures took a lot more time to recede in many advanced economies where it is assumed that inflation expectations are well anchored.
This is not what standard textbooks tell us to expect. Second, despite several calls for price controls, it is clearly monetary policy action that did most of the work in bringing down general inflation. That is where the textbook medicine did its job.
These two inconvenient facts are a challenge for economists in opposing camps—the first for those following the mainstream and the second for those who identify themselves as heterodox.