The International Monetary Fund has caused some consternation with the long-range forecasts in its April World Economic Outlook. It predicts that once the current bout of nasty global inflation abates, interest rates will return close to zero. If the IMF is on the money with this big-picture call, it will shred whatever is left of central bankers' credibility.
The IMF reckons most economies will subside into anemic growth, in turn curbing prices. If this really is to be our fate, then the last three years of plunging, then soaring, borrowing costs will have been a round trip of angst leaving us back where we were — with gross domestic product floundering.
That view contrasts with the current aggressive stance adopted by policymakers, with words and actions arguing that inflation must be beaten at all costs by ever-higher interest rates with growth left to look after itself. There have been plenty of warnings that far too much pandemic stimulus was poured in from all angles and left in place for far too long. But if central bankers are bounced into reversing course and slashing rates so soon after tightening policy, it will bring into question their collective ability to meet their remit.
It is important to distinguish between making short-term economic estimates, which are often a lot harder to get right than longer-term trends. The IMF does allow for alternative scenarios particularly with regard to whether public debt levels rise or fall. And not everyone agrees with its conclusions. Former US Treasury Secretary Larry Summers reckons rising government borrowing will result in real interest rates, net of inflation, as high as 2%, more than double the pre-pandemic levels.
In fairness, the IMF's central assumption is for mean reversion back to the post-global financial crisis status quo. The report refers to a natural interest rate known as R*, a conceptual target where official benchmark borrowing costs are neither too low to trigger unwarranted inflation nor high enough to smother economic growth. It is this holistic balancing point that armies of central bank economists are searching for, without ever quite knowing if they’ve arrived. Note that the IMF expects the big growth economies of India and China to suffer increasingly from similar depressive effects as more mature developed economies, thereby also requiring a lower natural interest rate over time.
While logical, it’s somewhat depressing to think that little has fundamentally changed following the global economy being suddenly shut down then restarted. Slowing productivity growth, ageing demographics, de-globalization, the shift to greener economies and how much extra government debt is required to facilitate that change are all potential factors to push down natural interest rates over time. Indeed, the futures market is anticipating that the Federal Reserve will be cutting rates before the end of this year, which is not in line with the commentary coming from Fed officials.
But central bankers are currently stuck having to justify more aggressive action is still needed, when slower inflation and weaker growth might be coming our way regardless. There has been a vast amount of central bank self-justification of how neither the pandemic nor the huge spike in energy prices were within their control; thereby no real blame can be attached to their collective inability to either predict or then curtail surging price gains. Raising rates until there’s solid proof the lagging indicator of core inflation is trending lower risks luring policymakers into making a second avoidable mistake. Overtightening and precipitating recession (or indeed a credit crunch) would cause widespread and deserved opprobrium, potentially undermining economic confidence. Central banks typically have dual mandates of controlling inflation and maintaining financial stability; the latter is just as important as calming consumer prices.
A ruinous downturn from repeated lockdowns was skillfully avoided with swift coordinated monetary and fiscal stimulus, only for policymakers to fall asleep at the wheel amid runaway inflation. A fair chunk of that might have been avoided if central banks hadn't become fixated with negative interest rates and ongoing quantitative easing for far too long. Hence, it might be smart now to consider a pause, if only to monitor the lagging effects of a year-long cycle of tightening financial conditions at every meeting.
Bloomberg Economics reckons the end may be in sight for the global rate-hike cycle. But for now the rhetoric remains pretty hawkish with growing hopes that the recent banking crisis is receding in the rear-view mirror. Nonetheless, if both growth and inflation subsequently evaporate, avoiding the ensuing blamestorm is going to be significantly trickier for our proudly independent monetary commanders.
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