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Searching for the Least Bad Version of Monetary Hell

Searching for the Least Bad Version of Monetary Hell

Friday, 20 May, 2022 - 04:15

Policy makers are fighting the devil in front of them rather than the goblin lurking around the corner. After years of wishing for and trying to conjure faster inflation, the overwhelming focus now is on slowing things down. A global slump seems increasingly possible — if such a downturn isn’t here already.

It’s been an extremely discouraging week: Company earnings in the US are falling short of estimates and Federal Reserve Chair Jerome Powell said he’s prepared to keep raising rates. In an unedifying spectacle, current and former UK officials are debating who’s to blame for the crisis, while the Bank of England governor conceded on Tuesday he feels “helpless” in the face of escalating global price pressures. In China, a string of indicators pointed to a collapse in business activity; the economy may not grow at all this quarter, thanks to Beijing’s zero-Covid approach. Bonds are rallying as fears of a new downturn propel a desire for havens.

Former Fed boss Ben Bernanke recently invoked the 1970s, hardly anyone’s idea of an exemplary decade, telling the New York Times that some version of stagflation — subpar growth and inflation that’s still too high for comfort — is likely in the next few years. “Even under the benign scenario, we should have a slowing economy,” he said.

Bernanke knows a thing or two about business cycles. Not only was his name on the door during the 2007-2009 fiasco, before joining the Fed as a governor in 2002, he was a member of the elite academic panel at the National Bureau of Economic Research that determines the beginning and end of American expansions. The committee declared the 2020 slump the shortest on record, lasting just two months.

Powell, meanwhile, almost sounds like he’s ready to bear another downturn as the price for bringing down inflation. That might sound dramatic, but it’s implicit in his remarks this week that he’s prepared for the economy to go beyond “neutral,” a vague space that neither spurs nor retards growth, to clamp down on prices. He wants to “see” clear evidence inflation is in meaningful retreat.

The risk is that the Fed waits for something very obvious, and the slowdown is in full sway by the time it gets to react — not unlike when inflationary pressures were building last year. “This approach, while justified on upside risk-management grounds, necessarily means that there is an elevated risk that the Fed ultimately overshoots a sustainable interest rates and has to cut again, as is our base case,” wrote Krishna Guha, a former Fed staffer now at Evercore ISI.

Powell began the year thumping the table at prices, having spent much of 2021 extolling the benefits of historic gains in the labor market that would bring long-term benefits to broad sections of American society. Yet when he displayed this new-found hawkishness in congressional testimony in January, it wasn’t framed as the choice between addressing rising prices or salvaging the post-Covid expansion. Inflation-fighting may have widespread political support in Washington, a recession much less so. We may be approaching a point where a damned-if-you-do, damned-if-you-don’t dynamic requires deciding on the least unattractive version of hell.

The last thing Powell wants it to sound like he’s out of options, like BOE chief Andrew Bailey (who may never live down that remark). Central banks need to project authority. The shift won’t begin with a sudden pivot from high-hawkishness to dovishness, nor will it happen overnight. Rate cuts shouldn’t be on the radar; inflation is too high. But there could well be a debate about the size of coming hikes and how much more — and for how long — they really make sense. Also look for policy makers to note that prices typically moderate in a slowdown, at least a bit. While this sounds a long way off, a pause in rate increases later this year or next isn’t implausible. “A moderation or even an end to quantitative tightening would be the next step, actual rate cuts would be the last resort, if recession was seen as inevitable,” wrote Roberto Perli and Benson Durham at Piper Sandler. (They don’t think this will happen in the near future.)

Policy is supposed to be forward-looking, an art that seems to have been lost somewhere along the way. Which war do central bankers want to fight: the one in front of their noses or the one that comes after that? It ought to be possible to combat prices while thinking about how to win the peace. Officials don’t have to be helpless, let alone hapless.


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