This week, between August 25 and 27, the annual Jackson Hole Economic Symposium will take place, hosted by the Federal Reserve Bank of Kansas City. Central bankers, treasury officials, economists and financial market participants are invited to attend. The focus of interest will be Fed Chairman Powell’s speech on August 26.
Low inflation environment
Until last year, most central banks in the advanced economies had still assumed a sustained low-inflation environment. The rising inflation at that time was seen as temporary. But much has changed within the past twelve months.
Inflation rates have continued to rise to high levels in many countries. The initial inflation drivers were pandemic-related. The supply of goods was unable to keep pace with the rapid increase in demand for goods. Added to this were sharp rises in energy and food prices, mainly due to the war in Ukraine, and increasing price pressures in the services sector as a result of the reopening measures. Meanwhile, pass-through effects to numerous other price components are evident. The key question is whether there will be secondary round effects (i.e. a wage-price spiral).
Tight labor market
Classically, central banks try to explain current inflation with the Phillips curve. Here, inflation is related to two explanatory factors. First, the labor market. In general, the more the current unemployment rate is below the unemployment rate adjusted for the business cycle (the structural unemployment rate), the greater the inflationary pressure. In fact, currently in many countries the labor market is very tight.
Inflation Estimates Were Usually Wrong
Second, current inflation is assumed to be influenced by either inflation expectations or past inflation. The method of using long-term expectations of consumers, firms, economists, and market prices for inflation estimates is increasingly criticized. At the theory level, this was a nice advancement. In practice, however, it has turned out to be rather useless because the estimates were too often far from the realized values.
Instead, the relationship between past inflation rates and current inflation is increasingly accepted as an explanatory factor for current inflation. This is referred to as persistence. Current estimates suggest that persistence has increased. That is, if inflation has been low within a given time period, say four quarters, inflation will remain low. If inflation has been high, inflation remains high. If the current increased persistence becomes entrenched, it can probably only be broken if the central bank acts very restrictively. Similarly, Fed Chairman Paul Volcker triggered a recession (rising unemployment) in the early 1980s with large rate hikes to depress inflation. However, although inflation actually began a downward trend in the 1980s, persistence remained high until the early 1990s. This can also be seen from the fact that, during this period, long-term inflation forecasts were always too high (see above). So it can take a long time to tame inflation fears when they first start to rise.
Restrictive monetary policy
In order to prevent the link between past and current inflation from becoming entrenched (persistence), central banks are currently raising key interest rates as quickly as possible. But to what level? Many central banks are signaling that they will follow a restrictive monetary policy if necessary (to dampen economic activity and inflation). The interest rate level adjusted for inflation (real interest rate) should become positive. However, there is one important question that no one can answer satisfactorily at present. What should be the value of the inflation rate used to calculate the real interest rate?
Erste Asset Management’s current estimate for underlying inflation in the US is 4% annualized. Comparables: personal consumption expenditures deflator: 6.8% in June, consumer price inflation in July: 8.5%, central bank target: 2%. If the inflation estimate is correct, a policy rate above 4% is needed to achieve a positive real interest rate. However, market prices reflect an end to the rate hike cycle in March 2023 at just under 3.7%. Next Friday, Fed Chair Powell will have the opportunity to influence market expectations. The hopes of some market participants that the decline in consumer price inflation from 9.1% in June to 8.5% in July means a less hawkish (hawkish) Fed policy may be disappointed. This is because the labor market is very tight and persistence has risen.
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