Despite the threat of recession, the central banks must stay the course

by time news

Dhe stock markets around the world breathed a sigh of relief this week when the central bank in Australia raised its key interest rate by just 0.25 percentage points, citing the risks to the economy. Could Australia set an example and prompt other central banks to raise interest rates less than previously expected? is the question from those who fear a deep recession.

The hope may be in vain. In a speech just a few days ago, Isabel Schnabel from the Governing Board of the European Central Bank emphasized the need for further interest rate hikes. In an uncertain world, where there is a risk that people are not confident that inflation will quickly return to its target of 2 percent, monetary policy must be robust.

Similar tones can also be heard from senior Fed officials. The reason is simple: the earlier assumption of a significant drop in the inflation rate in the coming year can no longer be upheld. Even assuming the economy falls into recession, lower inflation rates do not appear imperative.

Real interest rates matter

The monetary policy debate is complicated by ambiguities about the interpretation of current monetary policy and the lack of reliable economic forecasting models in uncertain times. Some critics consider the monetary policy to be too restrictive because the central banks are in the process of significantly increasing their nominal interest rates.

The problem with this argument is that economic decisions are based more on expected real interest rates than on expected nominal interest rates. When assessing a key interest rate, it makes a huge difference whether the expected future inflation rate is 1 percent or 10 percent.

In view of the very high inflation rate of 10 percent and the prospect of continued painful currency devaluation, the real key interest rate in the euro zone would still be negative even after further interest rate increases, taking inflation into account. It is difficult to argue that such interest rates choke the economy. Some economists are also finding it difficult to find their way into the new world in the first significant phase of inflation in half a century.

Knight in shining armor

Another question is how much the key interest rate must rise in order to gradually take pressure off the inflation kettle by dampening overall economic demand. There is a lack of suitable economic models that can be applied in the current situation. Central banks are believing that interest rates do not need to rise close to inflation today, as was observed in some countries half a century ago.

One might also question whether today’s financial system could cope with such sharp rises in short-term interest rates. In Germany, it was often heard that higher interest rates in the euro zone would not be possible because the Italian state would then go bankrupt. Something completely different happened: after the sharp increase in British bond yields after the announcement of tax cuts almost two weeks ago, the Bank of England had to calm the market for a short time with bond purchases because concerns about the financial stability of British pension funds, which are heavily invested in long-dated government bonds, could not be ignored became.

The size and vulnerability of modern financial markets do not release modern central banks from the expectation of being ready to rescue them in times of need. That doesn’t make their core task of securing monetary value any easier.

This core task is forcing central banks to resolutely continue their fight against inflation. If people lose confidence in monetary policy and expect high inflation rates for a longer period of time, there is a risk of a spiral of sharply rising prices and wages. It would be wrong to raise hopes that inflation would be tamed in the long term by capping individual prices.

Historical experience does not support such hopes, for convincing reasons. The 1970s also do not support the thesis, which has been warmed up again, that the loss of domestic purchasing power through the purchase of expensive energy from abroad will put the inflation rate under noticeable pressure. The responsibility of monetary policy for combating inflation cannot be defined away.

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