Central banks insist they are not done raising interest rates yet, with inflation still well below the 2% target. The result is that the EKT is currently at the highest interest rates in its history and the FED is at the highest interest rates in 22 years.
At the same time, various side effects of high interest rates are already being recorded. In the US the policy of increasing the key interest rates created very big problems especially for banks that had government bonds issued in times of much lower interest rates, as a result of which they now have a significant appreciation of their value. In Great Britain there was a mini-crisis of the insurance system again due to the problems in placements in government securities brought about by the big change in interest rate policy. In Germany, which is in recession, there is a question to what extent the ECB rate hike should translate into corresponding increases in both deposit and lending rates.
Is 2% the best target for inflation?
2% inflation is a kind of religious dogma among economists. It is considered to be an ideal inflation that both avoids all the destabilizing problems of a prolonged inflation and the difficulty of real economic planning caused by the prolonged double-digit inflation of the 1970s, but also leads to the recessionary dynamics of deflation.
Of course this did not necessarily mean 2% inflation. It basically meant low inflation. It is characteristic that even EU convergence criteria, first formulated in the Maastricht Treaty, do not include an absolute numerical target but a variation: the average inflation on a twelve-month basis must not exceed by more than 1.5% the average inflation of the three countries with greater price stability.
But also in the USA, where the mandate to the FED includes both price stability and full employment, it was in the 1990s, under the guidance of Alan Grispan, that they began to set a reference target of 2% inflation and only in 2012 was explicitly established as a target in relation to rising inflation.
However, there have been voices from time to time arguing that other inflation targets could be set, and that for example even 4% inflation might well be compatible with economic stability and growth.
The period of deflation
Of course, for a long time this discussion was somewhat philosophical, as there was no real inflation problem, especially in the Eurozone. Instead, what prevailed, in the aftermath of the 2008 financial crisis, were dynamics of stagnation and deflation. This meant that the problem in the 2010s was that in Europe in particular inflation was consistently running below the 2% target. This gave rise to another fear which was precisely deflation, which was essentially treated as a symptom of recessionary tendencies.
Combined with the need to avoid a new major economic crisis, this led to moves to stimulate economic activity, through “quantitative easing” policies, but also to a permanent decline in EKT interest rates, up to the point of negative interest rates.
In fact, this change in way of thinking seemed to be maintained when the first inflationary pressures began to be recorded again in the opening of the economy after the pandemic. At first it appeared that central banks would not move immediately to interest rate hikes, as the main anti-inflation measure, but they soon shifted in that direction.
The problem with anti-inflationary policies
However, the problem is not only about where the inflation target can be set. It also concerns the theory that still dominates about the causes of inflation.
And this is because, since the 1970s, an interpretation of inflation has prevailed that gives weight to excess demand on the part of consumers, which usually translates into excess demand on the part of wage labor.
If the cause of inflation is excess demand then it follows that the only “cure” is a policy of high interest rates that will raise the cost of borrowing (be it mortgages, consumer loans, or business loans) to slow spending and investment and thus the demand to harmonize with the supply. In practice this meant that unemployment rose and real wages fell.
However, this theory did not address what happens when the problem is not excess demand but insufficient supply, that is, when the other side of the price equation is ignored.
And this is because if anyone looks at the situation immediately after the pandemic, then they will find that we did not have any excess demand, nor any overinflation of the part of the total product that went to wages.
What we had was a time when economies were recovering, but there were labor shortages in some industries and a lot of obstacles and blockages in supply chains, including the problems created by the war in Ukraine. Moreover, it was at this juncture that a number of companies, mainly food and energy multinationals, chose to raise prices in order to maintain or even expand their profit margins, creating a trend that was followed by companies in other sectors. All this was exacerbated by developments such as e.g. the turmoil in world grain trade due to the war in Ukraine and in particular the collapse of the agreement on Ukrainian grain.
This means that a policy was followed based on an analysis of inflation that did not match the actual developments themselves.
The difficult matchup
Obviously, one could argue that even if the theoretical starting points of raising interest rates as an anti-inflationary policy are flawed, if economies are currently faced with high interest rates they will inevitably acquire a recessionary dynamic that will eventually lead to a retreat of product prices.
However, the reality turns out to be somewhat more complex. Headline inflation may have eased, but core inflation, which excludes food and fuel and reflects the underlying dynamics of an economy, is holding up.
At the same time, despite the increase in interest rates, the situation in the labor markets does not seem to have been affected and, on the contrary, employment levels are maintained at high levels.
Can inflation subside without a recession?
Signs of easing inflation were broadly seen as an element of optimism, in the sense that there is hope that advanced economies can get close to 2% without having to go through a recession.
Mainly this is based on the positive assessment of the growth trends of the US economy in the second quarter of 2023, while on the other side of the Atlantic things are more complex, if we consider the German recession.
However, a series of other economic indicators, such as corporate profits, which are falling in the US, the PMI indicators both in the US and – and above all – in the Eurozone which show a slowdown in developed economies, the decline in global trade, but also the increase in of bankruptcies in the US, all point to a slowdown of the economies in the direction of recession.
The fact that we are seeing even a slow decline in inflation over the same period shows that it was not so much the choices of the central banks that proved effective but the very fact that the global economy is slowing down.
And this means that inflation is not falling under the weight of the measures taken, but on the contrary, any decline could instead be considered a sign of optimism and a harbinger of recession.