For a few months this year, there was a rare moment of economic consensus. The central banks of the rich world, especially the US Federal Reserve, had unbridled inflation. They had to correct the mistake by raising interest rates sharply and quickly.
But as 2022 draws to a close, the uneasy peace between doves and hawks has broken down. Their latest disagreement on monetary policy is so big it’s as if they’re working with different sets of facts. While some economists warn that interest rates have now risen more than necessary to contain price growth, others say monetary policy hasn’t really tightened at all.
Like fixing a dislocated shoulder, fixing an inflation problem is supposed to be painful but simple. Every economist knows the maxim, dubbed the “Taylor Principle” after John Taylor of Stanford University, which tells central bankers to raise interest rates more than inflation has risen. To ignore the rule is to drop inflation-adjusted borrowing costs, administering a stimulus that makes the problem worse. To follow the principle, policymakers must increase real rates whenever prices accelerate. If they do, sooner or later the economy will slow down and order will be restored. Taylor’s principle is needed to stabilize inflation in state-of-the-art economic models. It is also common sense.
Yet, today, no major central bank follows this principle. Since the start of last year, inflation has risen by five percentage points in America, eight points in Britain and ten points in the eurozone. Central bank interest rate hikes are rapid by historical standards. But they are nowhere near keeping pace with this price growth. And that has led some economists to sound the alarm. “The Fed hasn’t put the brakes on yet,” said Jonathan Parker of the Massachusetts Institute of Technology after the last exceptional 0.75 percentage point increase on Nov. 2.
The problem is that although Taylor’s principle makes sense in theory, there is disagreement on how to apply it in practice. A true measure of real interest rates is forward looking. New borrowers and lenders need to know what inflation will be in the future, not what it was in the past. According to a survey by the New York Fed, consumers expect inflation of 5.4% over the next year. Mr. Parker subtracts this from the Fed’s target interest rate range of 3.75 to 4% to arrive at a negative real interest rate of around -1.5%. That’s below the pre-covid-19 pandemic rate and “very, very no contraction,” he says.
But why wait only a year? Many loans are granted over a longer period. And therein lies the dove calculation. Harvard University’s Greg Mankiw worries the Fed is overdoing it, as the five-year real interest rate on financial markets has risen sharply since the start of last year, by 3.4 basis points. percentage at time of writing. The classic version of Taylor’s rule, a more expansive cousin of Taylor’s principle, states that real interest rates should increase by half the increase in inflation. Look five years ahead in financial markets and take a measure of underlying inflation – Mr Mankiw points to a three point rise in annual wage growth – and real rates have pretty much kept pace of inflation. In other words, Fed tightening looks like too much, rather than too little.
The argument rests on what economists call “rational expectations”. Public opinion of what a central bank might do tomorrow is in theory just as important as short-term interest rates today. As a result, in modern economic models, it doesn’t matter if policymakers fail to raise interest rates above inflation at some point, notes Michael Woodford of Columbia University. Only the expectation of a systematic disregard of Taylor’s principle “indefinitely in the future” would cause monetary chaos. And Fed policymakers show little of that kind of contempt. The central bank has not finished raising interest rates: the markets expect them to exceed 5% next year. That might be enough to satisfy Taylor’s principle by then.
The belief that expectations are rational is usually associated with a conservative, warmongering view of the world, in which people belong to the species Homo economicus. Today, these arguments help the doves who argue that central banks should calm down. The Fed boasts of having turned positive real interest rates that are priced into financial markets at almost all horizons. The worst case of a yield curve that has escaped central bank control is in Britain, but ironically the problem is that markets seem to be expecting more interest rate hikes than the Bank of England would like. At its last meeting, the central bank predicted that the rate path envisaged by the markets would lead to a deep recession and bring inflation well below target. It’s almost as if the Bank of England has too much inflation-fighting credibility.
Even if Taylor’s principle is respected on a prospective basis, that is not the end of the story. The principle prescribes only the minimum tightening necessary to bring inflation back to the heel. If central banks narrowly breach the hurdle, inflation could take a long time to return to target. Another problem is that interest rates are supposed to rise even more when an economy is overheating. America, where there are almost two job openings for every unemployed person, clearly has this problem. Failure to respond could prolong the inflationary episode.
From the first principles
However, perhaps the best argument for further rate hikes is the poor track record of economic models and financial markets in forecasting inflation. Over the past year, the two have consistently underestimated his rise. In an uncertain environment, it makes sense to give more weight to data and less to forecasts, a point central bankers have begun to insist on. Applying Taylor’s principle with respect to realized inflation could make policymakers slower to react to a change in economic winds. But it is a price to pay to be sure to control inflation.
Learn more about Free Exchange, our column on the economy: The best way to bring manufacturing back (November 3)How to escape scientific stagnation (October 27) Why inflation refuses to go away (October 19)
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From The Economist, published under licence. Original content can be found at https://www.economist.com/finance-and-economics/2022/11/10/interest-rates-have-risen-sharply-but-is-monetary-policy-truly-tight