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Don’t Be Fooled: The World’s Central Bankers Still Love Inflation

Estimated Reading Time: 4 minutes

The Bank of Canada on Wednesday increased its policy interest rate (known as the overnight target rate) from 1.0 percent to 1.5 percent. This was the second fifty–basis point increase since April and is the third target rate increase since March of this year. Canada’s target rate had been flat at 0.25 percent for twenty-three months following the bank’s slashing of the target rate beginning in March 2020.

As in the United States and in Europe, price inflation rates in Canada are at multidecade highs, and political pressure on the central bank to be seen as “doing something about inflation” is mounting.

The bank is following much the same playbook as the Federal Reserve when it comes to allowing the target rate to inch upward in response to price inflation. The bank’s official position is that it could resort to very aggressive rate increases in the future in order to hit the 2 percent inflation target.

As in the US, it’s important for central bankers to sound hawkish, even if their actual policy moves are extremely tame.

The World’s Central Banks Are Still Committed to Monetary Inflation

In spite of their lack of any real action, however, Canada’s central bankers are comparatively hawkish when we look at the world’s major central banks. At a still very low target rate of 1.5 percent, Canada’s central bank has set a higher rate than the central banks in the US, the UK, the eurozone, and Japan. Indeed, in the case of the European Central Bank and the Bank of Japan, rising inflation has still not led to an increase in the target rate above zero.

  • Federal Reserve: 1.0 percent
  • European Central Bank: –0.5 percent
  • Bank of England: 1.0 percent
  • Bank of Japan: –0.1 percent

Moreover, the ECB and the BOJ haven’t budged on their subzero target rates in many years. Japan’s rate has been negative since 2016, and the EU’s has been negative since 2014.

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The Bank of England recently increased its target rate to 1 percent, which is the highest rate for the BOE since 2009.

In the US, the Federal Reserve has increased the target rate to 1 percent, the highest rate since March 2020.

However, it’s clear that none of these central banks are prepared to depart from the policies of the past twelve years or so, during which ultralow interest rate policy and quantitative easing became perennial policy.

The Federal Reserve has talked tough on inflation but has so far only dared to hike the target rate to 1 percent while inflation is near a forty-year high.

The Bank of England apparently suffers from the same problem, as Andrew Sentence of the UK’s The Times pointed out this week:

There is a serious mismatch between inflation and the level of interest rates in Britain. The rate of consumer prices inflation measured by the CPI is now 9 per cent—four-and-a-half times the official target rate of 2 per cent. The Bank of England is forecasting that CPI inflation will reach double-digit levels by the end of the year…. The older measure—the Retail Prices Index (RPI), which is still widely used—is already showing a double-digit inflation rate (over 11 per cent). Yet the official Bank rate has been raised to just 1 per cent, up a mere 0.9 percentage points on the near-zero rate during the pandemic.

This mismatch is not confined to the UK. In the US, where inflation is currently 8.3 per cent, the official Fed Funds rate is also just 1 per cent. And in the eurozone, where inflation is 8.1 per cent, there has been no interest rate rise at all from the European Central Bank.

This mismatch is not confined to the UK. In the US, where inflation is currently 8.3 per cent, the official Fed Funds rate is also just 1 per cent. And in the eurozone, where inflation is 8.1 per cent, there has been no interest rate rise at all from the European Central Bank.

In other words, even with these tiny rate increases, we’re seeing in the US and the UK, the Fed and the BOE aren’t as far behind the curve as the ECB, which in late May suggested it has started to consider reining in its easy-money policies. But in typical central bank speak, this means putting in place some small changes many months down the road. Specifically, ECB president Christine Lagarde stated that “based on the current outlook, we are likely to be in a position to exit negative interest rates by the end of the third quarter.”

Translation: “We might do something in five months.”

Anticipating the obvious response to this lack of action, Lagarde also insisted, “We are in a situation that is vastly different from the United States and we are actually perfectly on time and not behind the curve.”

Meanwhile, the Bank of Japan shows no signs of relenting on its dovish policy. In spite of the yen being in the midst of a historic slide compared to the dollar and the euro, BOJ governor Haruhiko Kuroda has made it clear he has no changes in the works.

A Strong Dollar by Default

This is all good for the dollar, and as we’ve seen in recent weeks, talk of a “strong dollar” has returned as other major central banks make their own fiat currencies look even worse than the dollar. The dollar, of course, is being rapidly devalued—but not as much as the yen or the euro.

Unfortunately, this gives the Fed in the US even more breathing room when it comes to getting away with inflationary monetary policy. Moreover, we have even started to hear complaints about this “strong dollar,” as we often hear from exporters, hack economists, and central bankers who think that a weak dollar helps the economy.

Perhaps the biggest danger here may be the adoption of an updated version of the late 1980s Plaza Accords designed to weaken the dollar. If the weak dollar advocates win that fight, we’ll be looking at a continued downward spiral in dollar purchasing power, all justified by the “problem” of a dollar that is too strong compared to other currencies. Weak dollar advocates are already working on it.

In the short term, however, the dollar is very unlikely to be the first domino to fall if the world is headed toward a sovereign debt or currency crisis. A crisis could actually trigger flight to the dollar and away from competing currencies. Ordinary people, however, will continue to face only bad options: continued high price inflation with only moderate wage increases—meaning declining real wages—or a recession that brings down inflation (both price inflation and monetary inflation) but drives up unemployment. Or there could be stagflation, with both a slowing economy and strong price inflation. None of the likely options are good news.

Key Rates

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This article was published by the Mises Institute and is reproduced with permission.

How the Fed Painted Us into a Corner

Estimated Reading Time: 5 minutes

The Federal Reserve System manages the US’s money supply, increasing or decreasing bank credit and other circulating media to reach a target interest rate usually announced at meetings of the Open Market Committee, which meets eight times a year. They met this week, announcing the first of several modest increases in the federal funds rate. To meet this target, the Fed will lower supplies of monetary aggregates until the federal funds rate reaches the desired target. This will primarily be accomplished by open market sales of US Treasury bonds, bills, and notes by the Federal Reserve Bank of New York. In order to raise the interest rate, the New York Fed will sell Treasury securities to remove bank reserves from bank balance sheets, and this will have a leveraged effect because any lending based on those reserves will also be removed from circulating as part of the money supply. The greater scarcity of loanable funds held by banks will raise interest rates.

Figure 1: Effective Federal Funds Rate 2000-2022

(Source: Federal Reserve Bank of New York, Effective Federal Funds Rate [EFFR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/EFFR, March 9, 2022.)

Figure 1 shows this target interest rate was kept below 2 percent in the aftermath of the 2001 recession. This mild recession resulted from the bursting of the late 1990s technology bubble. Low-interest rates in the 2000s triggered a new boom in real estate, construction, finance, and investments, including investments in highly-leveraged and non-transparent financial derivatives. Construction began to retrench as early as 2005, and the Fed realized the boom was not sustainable, so they tried to cool it down by raising interest rates. Unfortunately, the overheated real estate and financial markets did not respond right away, and when they finally did, the result was the 2007 financial crisis and the 2007-2009 Great Recession.

The Fed responded by bloating its own balance sheet by purchasing worthless derivatives from distressed banks, paying inflated pre-crisis prices in order to bail out distressed banks, insurance companies, and brokerage houses. Successive rounds of quantitative easing—eventually the Treasury and the Fed either got tired of numbering them, or perhaps were embarrassed—kept interest rates near zero until 2017. Among other things, this easy credit policy reinflated real estate markets. The federal funds rate was only allowed to rise to 2.5 percent in late 2018. This would have signaled some attempt at a return to normalcy, but then COVID-19 hit, and the Fed quickly flooded financial markets with additional liquidity and bank reserves, keeping interest rates back at near-zero levels. Rent moratoria and near-absolute shutdowns of restaurants, hospitality, travel, and manufacturing created an even greater loss of jobs and output than we saw during the Great Recession.

For the past few months, the Fed has finally been facing the prospect of inflation. After increasing the money supply dramatically since the start of the Great Recession, we now have 7.5 percent consumer price index (CPI) inflation over 2021, accompanied by 24 percent broad producer price index (PPI) inflation—this suggests even higher CPI inflation in our future. Some industry-specific PPIs have increased even faster; for example, the PPI for metals and metal-producing industries increased an incredible 45 percent over 2021. These rather frightening figures indicate higher costs of production that will eventually be passed on to consumers.

Supply shocks like the turmoil in global energy markets due to the Russian invasion of Ukraine are not the result of loose monetary policy we can blame on the Fed, so while rising gasoline prices clearly contribute to further raising the CPI and the inflation rate, they are not the result of an expansionary monetary policy. Still, the Fed has much to atone for.

Figure 2: M1 and M2, 2000-2022

(Source: Board of Governors of the Federal Reserve System (US), M1 [M1SL]; M2 [M2SL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M1SL, March 9, 2022.)

M1, or transactions money, consists of currency and coins in circulation, plus ordinary checkable deposits. These earn little or no interest, and can be spent without delay. M2, or savings money, is a broader measure of the money supply, and Figure 2 shows that until 2020, M2 was roughly four times the size of M1. M2 includes M1 but adds a number of interest-earning assets people typically use as savings assets. These assets are less liquid because they generally have to be converted to an M1 asset before they can be spent—transferred to cash or checking. Both M1 and M2 had been increasing steadily, and even at a moderately accelerating rate prior to the pandemic. This would have caused problems at some point, both in terms of inflation, and creating an unsustainable boom in investment that would eventually cause a recession.

Then the Fed responded to COVID-19 by further increasing M1 and M2. Although M2 only rose moderately, that sharp uptick in 2020 is still alarming and quite unprecedented in its own right. This is not a money supply that is being managed responsibly. The really remarkable event shown in Figure 2 is the virtual removal of traditional saving assets from the economy. These were things like savings account balances, money market mutual fund shares, certificates of deposit (CDs), etc. These were the differences between M1 and M2 and they used to account for up to 80 percent of M2. Since the pandemic, they only account for about 5 percent.

Why this happened is easy to understand in light of the near-zero interest rates these savings assets are currently paying. As long as savings accounts or CDs pay zero interest, there is little incentive not to keep that money in cash or checking. As the Fed starts raising interest rates, incentives will change, savings assets will become more attractive, and M1 should start to become a smaller fraction of M2. However, the Fed has managed to engineer a situation where prices are literally skyrocketing, while simultaneously supply constraints hobble any economic activity that hasn’t already been crippled by regulatory constraints.

It is never easy for policymakers to raise interest rates, but it is much easier for them to do that when the economy is overheating, prices are rising, and unemployment is low. Right now, we have a moribund economy with truly unspectacular economic growth. That would be bad enough, but it remains unclear how sustainable even this weak growth will turn out to be without serious structural reform. The one saving grace of our current situation is that unemployment remains low, but that fails to tell the whole story because our current low unemployment is due in part to unprecedented numbers of potential workers who are just not making themselves available in labor markets—the labor force participation rate has not been this low since 1977—though it is currently headed in the right direction. Low GDP growth and low unemployment rarely happen at the same time.

Each time the Fed raises interest rates, investment spending and investment borrowing will take a hit, and this may contribute to higher unemployment and lower labor force participation. Those outcomes will put pressure on the Fed to lower rates, or at least either delay raising them further, or raise them in smaller increments. If the Fed puts off raising rates to where they need to be for a healthy economy, inflation will get further out of control. With interest rates as low as they have been for most of the period following the Great Recession, the Fed really cannot squeeze out much short-run stimulus by lowering them further.

Over the months and years to come, it will be very interesting to see how faithfully the Fed pursues its policy of returning interest rates to normal and sustainable levels—approximately 3-4 percent for the federal funds rate. Every time the Open Market Committee meets for the next several years, they will face simultaneous pressure to lower interest rates to stimulate the economy and counteract higher borrowing costs, and pressure from other quarters to raise interest rates to fight inflation.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.