The difficult task of central banks

BarcelonaThe eurozone has reached a new inflation record with an annual increase in consumer prices of 10.7%. Correcting this inflationary drift with a restrictive monetary policy is both urgent and necessary. To understand how to do this, the reference is the historical precedent of the United States of the 1980s with the anti-inflationary monetary policy implemented by Paul Volcker. The inflationary drift was increasing, and went from 6.7% in 1977 to 13.3% in 1979. The source of inflation at that time, as now, was the increase in the price of oil, first with the creation of OPEC (in 1973), and then with a second shock following the Iranian revolution (1979).

The Federal Reserve launched an aggressive monetary policy that led to a benchmark interest rate of 20% in June 1981. As a result, the prime rate also rose to 21.5%. The US economy went into recession and the unemployment rate rose to over 10%. Inflation subsided, falling to 3.8% in the following four years and 1.1% in 1986. Now, neither the Federal Reserve nor the European Central Bank has succeeded in controlling inflation. For several reasons.

First, with some optimism, inflation forecasts were not catastrophic. The Federal Reserve erred in December 2021 when it calculated that 2022 inflation would be just 2.6%, when prices were already rising more than 5% annually. The IMF and the European Central Bank also failed, underestimating inflation in the first quarter of 2022 by two percentage points. These mistakes have their origin in three shocks geopolitical

The first is the supply chain crisis, as a result of the confinement and the segmentation of the world market, partially predictable but with effects that are difficult to pinpoint. The second, currently more visible, is the increase in the price of oil, gas and raw materials. According to IMF estimates, last year 66% of the rise in prices in the euro zone was due to disruptions in production and higher commodity prices. And the third, as obvious as it is unpredictable, is the war in Ukraine.

Companies against the ropes

these shocks have made the task of central banks difficult. Indeed, increases in food and energy prices are highly volatile and distort inflation data, so core inflation, which ignores them, has an easier path to predict. However, at this time, the increase in these prices has not been transitory, but persists. The increase in the cost of energy, be it diesel, gas or electricity, has put companies against the ropes: assume losses and increase prices.

Although in the short term companies may have negative margins, in the longer term increasing the price of their products is the only alternative to bankruptcy. This effect of the increase in the cost of energy has occurred in all countries, in all sectors and, for the moment at least, is more important than the well-known spiral between prices and wages.

A relevant consequence of the inflation data is that central banks updated models to account for these different effects. Despite this, it will not be easy to reduce the increase in prices. Indeed, the expansionary fiscal policy that tries to limit the impact of the pandemic is still active. Possibly, the success of the Volcker monetary policy was the reduction in demand generated by the increase in interest rates. Now, instead, we will observe expansionary fiscal policy as opposed to restrictive monetary policy, which necessarily limits the power of monetary policy to end excessive inflation.

A government can hardly remain inactive when seeing the economy enter recession, and the temptation will be to counter monetary policy with a more expansive fiscal policy: a contradiction.

UPF professor