Erste Asset Management

Monetary tightening even as growth slows further?

Monetary tightening even as growth slows further?
(c) Wolfram Steinberg / dpa /

Hawkish Central Banks

Central banks in advanced economies are raising their respective policy rates at a rapid pace. Some of them, notably the US Federal Reserve, explicitly profess to pursue tight monetary policy for some time to generate lower growth (below potential) and a weaker labor market. This is to prevent the transition from a low to a high inflation regime. This is because when inflation rates remain at a high level for an extended period of time, inflation gets a lot of attention and inflation expectations rise. Once inflation becomes anchored at a high level, it is difficult to break this high persistence. A particularly restrictive monetary policy, as in the US. in the early 1980s, would be necessary for this.

Last week, three major central banks raised the key interest rate further. In Australia, the key interest rate was raised from 1.85% to 2.35%, in Canada from 2.50% to 3.25% and in the euro zone from 0% to 0.75% (deposit facility). The guidance of market expectations (forward guidance) pointed to further significant key rate hikes at all three central banks. The US central bank and the central bank in the United Kingdom are expected to raise their key interest rates by 0.75 percentage points on September 21 and 22 respectively (Fed: to 3.25%; Bank of England: 2.5%).

Focus on persistence

Finding the right level of key interest rates is, by its very nature, not easy. No one currently understands inflation dynamics in a satisfactory way. The Phillips curve is the standard tool used by central banks to describe inflation. Unfortunately, there is currently increased uncertainty in all three subcomponents:

  • How strong is the relationship between the unemployment rate and wage inflation? Currently, unemployment rates are particularly low in numerous countries. In the USA in particular, the labor market is very tight. In any case, the risk of secondary round effects (wage-price spiral) has increased.
  • Will inflation expectations rise permanently? Taking into account the increased correlation between current and past inflation (persistence), the risk of this has increased. This is the main reason why central banks are acting so quickly. They want to prevent persistence from becoming entrenched.
  • Do external price shocks have a permanent effect on inflation? First the goods price inflation during the pandemic, then the big energy price shock due to the war in Ukraine. Until recently, it was the assumption of central banks that price shocks would have only temporary effects. However, it has turned out that the spillover effects (from energy prices to the other price components) are larger than originally thought.

Finding the right dose is difficult

This also means that we do not know the level of the inflation rate with which the real interest rate is to be calculated. But the latter ultimately determines whether interest rate policy is restrictive, neutral or expansionary. Moreover, there is great disagreement about where the real neutral interest rate actually lies. Above this interest rate level, monetary policy theoretically has a restrictive effect, below it an expansionary one. Because the two variables 1) underlying inflation and 2) real neutral interest rate level are difficult to assess, ECB President Lagarde did not want to commit herself during the press conference last Thursday to which level the key interest rate could ultimately be raised. However, she did say that monetary policy is still expansionary at present and that key rate hikes can be expected at the next council meetings. Markets are now pricing in a 1.80% policy rate by the end of the year and a 2.3% policy rate by July 2023. Given the likely recession in the euro zone, this reflects a hawkish stance on the part of the central bank.

Complicating matters further is the fact that monetary policy in the eurozone does not work the same way in every country. In July, the ECB invented the Transmission Protection Instrument (TPI) to contain any potential distortions that key rate hikes could have on weaker government bond markets such as Italy.

However, the other central banks are also confronted with the problem of weakening growth. Numerous survey-based indicators continued to fall in the month of August. Last week, the global purchasing managers’ index for the manufacturing and services sectors fell from 50.8 to 49.3. This level suggests real economic growth below potential for developed economies (DME). The downside risks are most pronounced in the manufacturing sector. Low ratios of new orders to inventories point to an imminent contraction in manufacturing in the DME. What impact a growth slowdown or recession (in the euro area) will have on central banks’ willingness to fight inflation could have long-term implications for the inflation path. Stopping policy rate hikes early because unemployment rates are rising would make a stagflation environment like the 1970s more likely.

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Prognoses are no reliable indicator for future performance.


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