Have central bank interest rates in the United States and the Eurozone peaked? If so, how quickly is it likely to decline? After central banks were forced to tighten their monetary policies significantly since mid-2021, it seems that their next step is still uncertain.
No matter what central banks may announce what they will do, developments on the ground always have the final say. If core inflation falls rapidly towards its target as many currently expect, central banks will have to ease their policies. Just as loss of credibility is very harmful when inflation is high, it is also very harmful when it is very low.
Inflation falling below target and monetary policy pushing in a specific direction is a highly undesirable approach. It appears that the time to respond to these risks is imminent, especially in light of the delayed transmission of the impact of previous tightening decisions.
Jerome Powell, Chairman of the Federal Reserve, and Christine Lagarde, President of the European Central Bank, reiterated their plans not to ease soon. Intervention rates have remained stable for some time, with the federal funds rate at 5.5% since July, and the European Central Bank’s deposit rate at 4% since September.
However, Powell warned this month that the task of returning inflation to the 2% target still has a long way to go. Likewise, Lagarde told the Financial Times last week that euro zone inflation would fall to its 2% target if interest rates remained at current levels “for a long enough period.” “This does not mean that we will see a change in the next two quarters,” Lagarde said. “Long enough time means a really long time.”
Assuming there are no surprises, the reasonable conclusion from all this is that the benefits have peaked. But central banks are currently confirming their plans to fix interest rates at high levels. There is a justification for declaring these intentions, which is that the assurances are a political tool in and of themselves. If markets are convinced that a rate cut is imminent, it will likely push bond prices higher, which will lower interest rates and ease monetary conditions.
Central banks do not want to undermine tight financial conditions in this way, given the uncertainty about the outlook. Instead, they prefer to keep the status quo until they are sure that their economies do not need such extreme conditions.
It’s understood so far. But the question is: how uncertain are the forecasts? The answers of optimists for both the US and the eurozone in this regard vary, but they lead to the same conclusion: that the threat posed by inflation is receding more quickly than central banks indicate.
Economists at Goldman Sachs clearly pointed out this issue in their recent analyses. In the United States, they argue that core inflation has fallen sharply from its peak during the pandemic and will begin its final decline in 2024.
Experts expect inflation to continue to decline, due to the return of balance in the car, residential rental, and labor markets.
Experts add that wage growth has mostly receded to its sustainable pace of 3.5%. However, core personal consumption expenditures inflation is expected to decline to approximately 2.4% by December next year.
Regarding the euro zone, Goldman Sachs experts expect core inflation to return to normal in 2024, as core inflation has declined more than expected in recent months, and wage growth shows clear signs of slowing.
While inflation is slowing on both sides of the Atlantic, the shocks and economic performance have been very different on both sides. The most notable variation in growth rates this year. Consensus expectations for growth in the United States and the Eurozone for 2023 declined in 2022, as estimates for 2023 growth fell from about 2.5% in January 2022 to nearly zero at the end of last year. However, estimates for the United States currently indicate growth of 2.4%, while growth for the Eurozone is heading for only 0.5%.
The combination of strong US growth, with low unemployment and falling inflation, sounds like “perfect disinflation,” something I personally do not believe in. But let us leave the answer to the question of the reasons for this happening for later. As for output, declining inflation seems less ideal in the eurozone. This is not surprising, as inflation and weak growth were reinforced by the energy shock caused by the war between Russia and Ukraine.
So look forward. According to what John Llewellyn said, the US economy may witness much greater weakness next year, and as for the growth of the euro zone, the relatively optimistic expectations of Goldman Sachs are for an expansion of 0.9% in 2024. This assumes that the European Central Bank will ease its monetary policy in response. The good news regarding inflation.
Central banks must look forward and pay attention to the delay between decisions and their impact on economic activity. In the meantime, these banks should take a look at the monetary data, where the annual growth of the money supply (M3) is at very negative levels.
In this context, monetary data should not be a goal in itself, but it should also not be overlooked.
In short, it seems increasingly plausible that the tightening cycle has come to an end. It is also likely that the start of easing appears closer than central banks indicate. If this does not materialize in practice, there is a risk that it will be too late to avoid a costly economic slowdown that may result in a return to very low levels of inflation. However, none of this seems certain, and policymaking is currently going through a really difficult phase in the current cycle.
We also need to draw some lessons. The first is that the extreme flexibility of the economies confirms that the tightening was justified. Otherwise, how much would US inflation have been without this tightening? The second is that inflation expectations remained certain, despite the large jumps. So, it can be said that the inflation targeting system has performed its role well.
The third lesson is that labor markets have performed better than expected, and the fourth is that forward guidance is risky, and policymakers need to think carefully before committing themselves to something they may soon be forced to violate.
Finally, central banks should not fight wars for too long just to get the start. Thus, the final stage may be the most difficult, but banks must be vigilant as they cross the finish line.
2023-11-17 22:01:20
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