The US Federal Reserve and other central banks must be proactive on inflation, but not overreact

In favouring shock therapy to contain inflation, the Fed and other central banks that appear to be following suit on tougher policies risk a harder landing for their economies
Should central banks act with impunity and expect governments and taxpayers to pick up the tab for all the damage wrought by recession?

David Brown

Published: 1:30am, 20 Sep, 2022

Why you can trust SCMP

Central banks have the bit between their teeth to take down inflation. Later this week, the US Federal Reserve looks set to announce another steep 0.75 percentage-point interest rate rise, the same as at the past two monetary policy meetings, in June and July.

Clearly, the Fed favours shock therapy to contain inflation and, in doing so, risks a harder landing for the US economy. The Fed is not alone, as the European Central Bank and Bank of England both appear to be following suit with tougher policy responses.

But, is it their remit to push economic activity back into recession, with its implied toll on business output and employment? Should central banks act with impunity and expect governments and taxpayers to pick up the tab for all the damage wrought by recession? It may be time for central banks to have a heart and avoid policy overkill, for the sake of global welfare.

The current global inflation spike is a supply-side shock, mainly caused by post-Covid-19 supply-chain issues and the Ukraine war. Global growth prospects can ill-afford another needless squeeze on supposedly non-existent demand-pull inflation risks. The US is already in technical recession after two successive quarters of negative growth and there is little that Fed policy can do to change two exogenous factors which are outside its control.

Of course, the Fed is deeply rattled about core inflation jumping to 6.3 per cent in August from 5.9 per cent in July, despite the headline consumer price inflation rate easing to 8.3 per cent, from 8.5 per cent, over the two-month period. The Fed must be proactive, but it shouldn’t overreact.

The worry for the Fed is that elevated inflation perceptions are becoming embedded in a psychology of rising prices, which could easily turn into a vicious wage-inflation spiral.

With US unemployment running at 3.7 per cent, the Fed considers that the labour market is already running too hot and interest rates need to go a lot higher than the current Fed funds range of 2.25 to 2.5 per cent to contain any further upwards wage drift. The only question is: how much higher?

With the annual growth in US average hourly earnings running at 5.2 per cent, which is well above the Fed’s 2 per cent inflation target, it’s easy to see why it wants to draw a line in the sand.

Using a traditional Phillips curve approach, comparing the inverse relationship between the rate of inflation and unemployment, headline inflation at 8.3 per cent and a 3.7 per cent unemployment rate are clearly inconsistent with the Fed’s long-term inflation goal.

The Fed figures it has to squeeze the economy a lot harder to get inflation back into line, tacitly hoping that the Ukraine war and the spike in global energy prices end in the meantime.

As inflation sticks and recession hits, prepare for five years of hard times

Fortunately, the Fed does have reasonable operating parameters as the overall policy objective is to hit the right economic conditions to promote sustainable, non-inflationary growth and job creation over the long term.

That means setting interest rates which can achieve its 2 per cent inflation target, with economic growth trending at its 2-2.5 per cent long-term potential, close to full employment at the same time. The Fed’s remit is not 2 per cent inflation at any cost, forcing the US government into plugging the gaps with fiscal reflation.

01:36

US Federal Reserve authorises another big rate hike in bid to curb inflation

Clearly, the Fed is on a mission to repair its tarnished inflation credentials, but it is not out to break the economy in the process. The policy bias is simply switching from pro-growth to inflation fighting, with a long-term target for Fed funds probably peaking in the 4-4.5 per cent range, without doing too much damage to growth or its inflation mandate in the process. The markets will be watching closely.

On Wednesday, the Bank of England is expected to hike its official interest rates by 0.75 percentage points, amid a mounting crisis for the pound, which has crashed to a 37-year low against the dollar. The UK government is learning an object lesson in how not to tinker with central bank independence. Earlier hints of possible political interference forcing the central bank into going for growth have not gone down well and hit the pound especially hard.

Markets seem in no mood for central banks to go easy on inflation.

David Brown is the chief executive of New View Economics