Inflation cannot be eliminated with words and conjuring up wishful thinking alone. Central banks must now quickly put their money where their mouth is, or they will lose credibility.
Have the central banks taken over political steering functions?
Inflation is a hot topic right now, not least for investors and their advisers. Central banks have started to tighten interest rates. Speculations about where interest rates are headed are booming. One must caution against a view that is relatively common, especially among financial analysts. She starts from the correct conclusion that the central banks are politically and economically severely restricted when it comes to raising interest rates, but erroneously concludes that one can therefore give the all-clear on interest rate developments: A long-lasting phase of high interest rates is hardly to be feared.
There can be no question of restriction
This view emphasizes that the central banks could not raise interest rates too much because of the heavy debt burden of governments and private individuals. Otherwise they would destabilize the financial system and the real economy. They would therefore now announce a sharp fight against inflation, but ultimately not go too far with interest rate hikes. At the first signs of a recession, they would quickly correct their policy again. Instead, they would try to control inflation with words and clever communication.
According to the NZZ of July 28, the majority of investors are now assuming that the US key interest rate will peak at just over 3 percent in the next six months and then tend to fall again. Expectations for Europe are significantly lower.
I share the opinion that the central banks will tighten their monetary policy too slowly and too timidly because of the immense level of debt at present. I have been pointing out for years – not least in this newspaper – that the great risk of the flood of liquidity created in the last decade and the low interest rate policy associated with it lies precisely in the fact that it will be extremely difficult politically to take this liquidity out of the market again ( or to immobilize them by paying interest on the banks’ sight deposits) if this becomes necessary to combat inflation. The rate hikes required for this would meet with great resistance. This is exactly where we are today.
The European Central Bank (ECB), which is only painfully slow to adjust its interest rate policy despite Europe-wide inflation of over 8 percent, illustrates this danger very clearly. The US Federal Reserve has acted more consistently so far. However, even with the latest interest rate hike, it is still in the process of changing its interest rate policy from extremely expansive to neutral. There can be no talk of actual restrictions yet.
In her case, too, there is a great danger that the monetary tightening will be canceled too soon. Too many in the USA, too, believe that the problem will be solved once inflation rates have peaked (“waiting for peak inflation”). As if inflation would return of its own accord to the 2 percent target afterwards!
Premature all clear
So it is indeed likely that central bank interest rates will remain (too) low, but unfortunately this is not good news. It is therefore hasty to give the all-clear on interest rate developments. We should remember that central banks do not have omnipotence over interest rates. You can determine the short-term interest rate, but not the interest rates across the entire range of maturities and investment objects. The longer they keep their central bank interest rates (too) low despite high inflation, the more the inflation process and inflation expectations will solidify. Once this has happened, the nominal interest rate is no longer primarily determined by the central bank interest rate. There are interest rate premiums due to inflation. Many market commentators seem to have forgotten this well-known connection. They therefore see the interest rate future far too rosy.
Inflation like the one we are experiencing today has never been dealt with by words and wishful thinking alone, especially not in a labor market that is running as hot as it is today. If central banks don’t back their words with action, they will end up losing all credibility.
Of course, the central banks could try to control the entire yield curve, including keeping long-term interest rates low (like the Japanese central bank is doing). But that is not compatible with a restrictive monetary policy aimed at combating inflation (just as little as the ECB’s attempt to limit the interest premiums on the government debt of its crisis countries).
The longer the central banks procrastinate, the higher the interest rate level will be in the end – because the inflation process will harden as a result and the inflation-related interest premiums will rise and because the central banks will then have to take countermeasures all the more.
Ernest Baltensperger is Emeritus Professor of Economics at the University of Bern.