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Central banks accept the pain now, fearing worse later

by SuperiorInvest

A day after the Federal Reserve raised interest rates sharply and signaled more to come, central banks in Asia and Europe followed suit on Thursday, waging their own campaigns to contain the outbreak of inflation that is fooling consumers and worrying policymakers around the world.

Central bankers usually move slowly. This is because their policy instruments are blunt and lag behind. Interest rate hikes taking place from Washington to Jakarta will take months to filter through the global economy and take full effect. Once Jerome H. Powell, chairman of the Fed he likened the creation of politics walk through a furnished room with the lights off: You walk slowly to avoid a painful outcome.

Yet the officials lessons from history who illustrated the dangers of suppressing price growth for too long, decided they no longer had the luxury of patience.

Inflation has been relentlessly fast for a year and a half. The longer it goes on, the greater the risk that it will become a permanent part of the economy. Employment contracts may begin to reflect the rising cost of living, companies may begin to routinely raise prices, and inflation becomes part of the fabric of society. Many economists think this happened in the 1970s, when the Fed tolerated rampant price increases for years—allowing the introduction of an “inflationary psychology” that later proved intolerable.

But the aggressiveness of monetary policy measures now underway is pushing central banks into new and risky areas. By tightening quickly and now at a time when growth in China and Europe is already slowing and supply chain pressures are easing, some economists warn that global central banks risk overdoing it. They can plunge economies into recessions that are deeper than necessary to contain inflation, thereby greatly increasing unemployment.

“The margin for error is now very thin,” said Robin Brooks, chief economist at the Institute of International Finance. “A lot of it comes down to judgment and how much emphasis you put on the 1970s script.”

In the 1970s, Fed policymakers raised interest rates in an attempt to control inflation, but backed off when the economy began to slow. This allowed for inflation stay elevated for years, and when the oil price spike hit in 1979, it reached unsustainable levels. The Fed, led by Paul Volcker, eventually raised rates to nearly 20 percent — and sent unemployment soaring to more than 10 percent — in an effort to combat rising prices.

This example weighs heavily on the minds of politicians today.

“We think the failure to restore price stability would mean a lot more pain later,” Powell said at his Wednesday news conference after the Fed raised rates for the third straight time by three-quarters of a percentage point. The Fed expects to raise borrowing costs by 4.4 percent next year in the fastest tightening campaign since the 1980s.

The Bank of England on Thursday it raised interest rates by half a point to 2.25 percent, even as it said the UK may already be in recession. The European Central Bank is similarly expected to continue raising rates at its October meeting to fight high inflation, even as Russia’s war in Ukraine throws Europe’s economy into chaos.

As major monetary authorities raise borrowing costs, their trading partners follow suit, in some cases to avoid large movements in their currencies that could raise local import prices or cause financial instability. On Thursday, Indonesia, Taiwan, the Philippines, South Africa and Norway raised rates and there was a big shift Swiss National Bank ended the era of sub-zero interest rates in Europe. Japan has relatively low inflation and keeps rates low, but that intervened in the currency markets on Thursday for the first time in 24 years to support just in light of all the actions of their counterparts.

The wave of central bank measures is expected to backfire and deliberately slow both interconnected trade and national economies sharply. For example, the Fed sees its actions pushing U.S. unemployment to 4.4 percent in 2023, from the current unemployment rate of 3.7 percent.

The moves are already starting to have an impact. Rising interest rates in many countries make it more expensive to borrow money to buy a car or house. Mortgage rates in the United States, they have returned above 6 percent for the first time since 2008, and the housing market is cooling. Markets swooned this year in response to tough talk from central banks about reducing the amount of capital available to large companies and reducing household wealth.

However, the full effect may take months or even years to manifest.

Rates are rising from low levels and the latest moves have yet to fully play out. In Europe and Britain, it is the war in Ukraine rather than monetary tightening that is pushing economies into recession. And in the United States, where the effects of the war are far less severe, hiring and the labor market remain strong, at least for now. Consumer spending may be slowing, but not falling.

That’s why the Fed believes it has more work to do to slow the economy — even as it increases the risk of a downturn.

“We have always understood that restoring price stability while achieving a relatively modest increase in unemployment and a soft landing would be very challenging,” Mr Powell said on Wednesday. “Nobody knows if this process will lead to a recession, and if so, how significant that recession would be.”

Many global central bankers have portrayed today’s burst of inflation as a situation where their credibility is at stake.

“For the first time in four decades, central banks need to show how committed they are to protecting price stability,” said Isabel Schnabel, a member of the European Central Bank’s executive board. he said at the Fed conference in Wyoming last month.

But that doesn’t mean the policy path the Fed and its peers are charting is unanimously agreed upon — or clearly the right one. This is not the 1970s, some economists pointed out. Inflation has not been raised for so long, supply chains seem to be healingand measures inflation expectations stay in control.

Mr Brooks of the Institute of International Finance sees the pace of tightening in Europe as a mistake and thinks the Fed could also overdo it at a time when supply shocks are fading and the full effects of recent policy moves have yet to be seen. play out.

Maurice Obstfeld, an economist at the Peterson Institute for International Economics and a former chief economist at the International Monetary Fund, wrote in recent analysis that there is a risk that global central banks are not paying enough attention to each other.

“Central banks are clearly scrambling to raise interest rates as inflation runs at levels not seen in nearly two generations,” he wrote. “But there can be too much of a good thing. Now is the time for monetary policymakers to raise their heads and look around them.”

Yet at many central banks around the world – and clearly at Mr Powell’s Fed – policymakers see it as their duty to remain resolute in the fight against price increases. And that is now translating into vigorous action, regardless of the looming and uncertain costs.

Mr. Powell may once have warned that moving quickly in a dark room can end painfully. But now it’s like the room is on fire: The threat of a stubbed toe is still there, but moving slowly and cautiously puts you in even greater danger.

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