“I think we now understand better how little we understand about inflation,” Jerome Powell said candidly in Sintra on Wednesday. In that leafy coastal town near Lisbon, the finer points of monetary policy are gathering every year, at the invitation of the European Central Bank (ECB). So also the chairman of the Federal Reserve, who encountered similar problems as on the home front. Inflation is far too high, it is unclear how long it will remain that way, and what the ideal remedy is.
One note of optimism is that central banks have at least begun to address the problem, said Agustín Carstens, chief executive of the Bank for International Settlements (BIS). ‘You see that interest rates are rising all over the world, and that it has therefore become more expensive to borrow.’ Central banks must act quickly and decisively before high inflation can settle, he advised. ‘Otherwise, the costs of getting it under control again will be higher.’
Powell didn’t let himself be told that twice. “It is essential that people understand our commitment to bring inflation back to our 2 percent target.” With an inflation rate of 8.6 percent, the Fed is still a long way from that. Successive rate hikes should cool the economy, removing upward price pressures. “Monetary policy remains a blunt instrument,” Powell said. ‘Of course there is the danger that we slow down the economy too much, but that is not the greatest danger. It would be a bigger mistake not to restore price stability.’
Dream scenario is lower inflation
The dream scenario is clear. “We want to return to a regime where inflation is so low that no one pays attention to it. You don’t want it to become rational for people to pay attention to high inflation as a result of a series of shocks.’ The clock is ticking, Powell acknowledged. ‘Inflation has been high for a year now. Nevertheless, we will avoid the transition from an environment of low to high inflation’, he insists. “It’s literally our job.”
Christine Lagarde also struggles with that challenge. The ECB expects inflation of 6.8 percent for the eurozone this year, more than three times the target. “There is a lot of uncertainty,” the ECB president said in a panel discussion. “We are closely following what is happening in energy, the war in Ukraine, wage negotiations and inflation expectations.”
The latest figures are discouraging. Eurozone inflation hit a record high of 8.1 percent in May, and economists expect it to rise further in June to 8.5 percent. On Tuesday, it appeared that inflation in Spain rose to 10 percent in June and to 9.7 percent in Belgium. In both cases, that is the highest level in more than 35 years. Lagarde noted that inflation in Germany has fallen slightly, to 7.6 percent. But according to ING economist Carsten Brzeski, this is mainly due to the tax cut on fuels that the German government has implemented, a support measure that expires in August.
Call for stricter monetary policy
This kind of government policy is not to everyone’s taste. For example, the chairman of the National Bank of Belgium, Pierre Wunsch, stated in Sintra that the ECB should raise interest rates faster if governments continue to stimulate the economy in this way. Protecting citizens against rapidly rising energy prices stimulates demand, which has an upward effect on inflation. And so, according to Wunsch, monetary policy must be stricter.
Nevertheless, the path of small steps still prevails at the ECB. In July, the key interest rate will rise for the first time in 11 years, probably by 25 basis points. More and more voices are bubbling in Frankfurt to push ahead. Lithuanian director Gediminas Simkus, among others, is pushing for an increase of 50 basis points. This would mean that the key interest rate in the ECB would be positive again for the first time in eight years.
“We are normalizing our policies,” Lagarde said. ‘What we do is not science. There is a certain art in it. It is not only driven by data and models, which have their shortcomings, but also by the exchanges of views in our policy meetings.’