In two weeks’ time, the US Federal Reserve will almost certainly raise interest rates. Next week a debate is likely to take place within the European Central Bank about when it should begin to wind down the extraordinary stimulus delivered through its quantitative easing programme.
Both economies are chugging along nicely. US consumer spending is accelerating after a slow start to the year. Unemployment in the eurozone fell last month to 9.3 per cent, the lowest since 2009, and in the US to a 10-year low of 4.3 per cent.
All seems set, then, for what sceptics of super-loose monetary policy like to call the “normalisation” of interest rates and the monetary stance in general. The only problem is that both central banks are supposed to be targeting inflation, which remains stubbornly low, its relationship with the apparent tightness in the economy showing few signs of replicating its historic pattern.
On the Fed’s preferred “core” measure, the rise in the personal consumption deflator stripping out volatile food and energy prices, annual inflation was 1.5 per cent in April. Not only did this remain uncomfortably far below the Fed’s 2 per cent target, but the rate has fallen since the beginning of the year, from 1.8 per cent in January. Inflation has equalled or exceeded 2 per cent for only five months since the economic recovery following the global financial crisis.
In the eurozone, it was revealed this week that consumer price inflation fell to a six-month low of 1.4 per cent in May, also well below any reasonable definition of the ECB’s target of “below, but close to, 2 per cent”. The ECB’s own projections show the core rate at 1.1 per cent this year.
In this context, the apparent determination of the Fed in particular to press on with interest rate rises looks a little peculiar. Having created expectations that it was likely to tighten policy with three quarter-point increases over the course of 2017, the Fed is acting more like a party to a contract that feels the need to honour its terms, than a central bank that takes the data as it finds them.
Fortunately, there appears to be more resistance to the danger of premature tightening at the ECB. Mario Draghi, the bank’s president, is siding with his chief economist in stressing the risks of planning to withdraw QE stimulus too rapidly.
There are two mistaken ideas at the heart of the urge to tighten policy too quickly.
The first is that interest rates need “normalising”, as though there were an eternal and fixed level of equilibrium real rates. The evidence that the real rate has substantially lowered, even before the global financial crisis, is strong.
The second is the belief that the output capacity of the economy, measured by the unemployment rate or by other metrics, is sufficiently well known that a central bank can safely raise rates on the basis of gross domestic product growth or increases in employment before it sees inflation start to rise. The history of the past few years, where inflation has continually undershot expectations despite recoveries in the major economies, suggests otherwise.
By themselves, a quarter-point increase in interest rates by the Fed, or the beginning of a discussion about withdrawing QE stimulus at the ECB, are unlikely to choke off recoveries in either economy. But both betray, at least in some quarters of those institutions, a misguided approach to monetary policy that ignores recent experience in favour of a default expectation that the future will be like the past.
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