Will the rise in the inflation rate above 3% in the Eurozone and the United States trigger a strong reaction from central banks?
This is the major question for the next two weeks. The ECB will meet on June 11, and the Fed a week later on the 16th and 17th. Faced with accelerating prices, should central banks toughen their stance or lie low? Discussions are in full swing among economists regarding these two options.
To shed light on the debate, reading an analysis of Jay Powell’s two terms as head of the US Federal Reserve is relevant. This is what two American economists from the University of Berkeley have done. Christine Romer and David Romer are well-versed in this exercise of linking macroeconomics with the actions, publications, and decisions of the central bank. (https://www.brookings.edu/articles/an-early-retrospective-on-monetary-policy-in-the-powell-era/).
There is no dogmatic model but a thorough and precise analysis of the interactions between macroeconomics and the central bank.
They conclude with six major points.
1. Monetary policy must be focused on its specific objectives (inflation and growth), conditioned by a model based on historical data and not on subjective expectations. Its ultimate goal is the short-term management of aggregate demand, not the reversal of structural trends.
The authors criticize the Fed for its delay in 2021 in assessing inflation, under the assumption that inflation would not react (flat Phillips curve).
2- It must act quickly and decisively to facilitate the management of overall demand. A gradualist approach, taking small steps, is not the most effective.
3- Inflation has negative effects even if inflation expectations remain firmly entrenched. Sustained price increases generate uncertainty and a loss of confidence in institutions. This is why the central bank must not risk inaction, especially if the shock is perceived as persistent.
4- Consequently, forward guidance, which aims to steer investor expectations, is effective in periods without shocks but proves to be a constraint in turbulent times. Central bank policy must be agile in order to act quickly and decisively.
5. The Fed’s balance sheet must remain large to facilitate liquidity management within the banking system. These liquidity needs, generally linked to prudential regulations, must be met to avoid creating a risk for the entire banking system (as seen in the repo market crash of September 2019).
6- The bank’s independence must allow it to make effective decisions for macroeconomic and financial stability. However, it cannot be the only institution to defend this status. It is above all a collective choice. It is a contemporary issue.
To be continued…
