There is agreement that the inflationary pressure has its origin mainly in these factors: the bottlenecks in the supply chains caused by the recession and the pandemic; the conditions of the labor market operating practically at full employment; the countercyclical fiscal policy in an unprecedented amount to mitigate the recession derived from the pandemic; the prolonged expansive monetary policy of zero interest rate and asset purchases by the Federal Reserve; and the Russian-Ukrainian geopolitical conflict that has resulted in sharp increases in energy, grain and food prices.
Monetary Policy in the United States
There is a popular saying among central bank monetary policy analysts that “central banks tend to tighten late, and when they do, they overdo”. (Central Banks are always late to tighten, and when they finally do, they tighten too much).
An important current of analysts maintains that the Federal Reserve (the Fed) indeed made the mistake of delaying the start of its cycle of interest rate hikes too long (see, for example, The Economist magazine, April 21, 2022). In hindsight, perhaps that mistake was due to the perception that a move to tight monetary policy would jeopardize the success of expansionary fiscal policy.
It is not possible to step on the accelerator and the brake simultaneously, defended the proponents, advocating fiscal-monetary coordination in the same direction. It was a risky bet: letting the fiscal stimulus be absorbed by allowing “some” inflation and then raising rates, despite voices like that of Larry Summers (former Treasury secretary), who clearly warned at the beginning of 2021 that the package of Biden’s $1.9 trillion stimulus could unleash inflationary pressures unseen in four decades. He was right.
Compounding the Fed’s mistakes, its monetary policy decision-making body (the FOMC committee) noted in 2020 that, in support of avoiding a severe recession, inflation above the 2% annual target could be tolerated for some time, as long as when on average it was 2%. Furthermore, to support this vision, it adopted a new monetary policy framework which it called “flexible average inflation targeting”. The consequence of this vision of temporary permissible inflation was to de-anchor the expectations of controlling inflation in the medium term.
Furthermore, as prices began to rise, real interest rates fell, exerting additional inflationary pressure. Now -after a few months ago the rhetoric of Jerome Powell, president of the Fed, has changed 180 degrees towards a restrictive monetary cycle- fortunately the Fed has abandoned that policy framework, returning to traditional inflation targeting with an inflation target of 2 percent.
How will the United States get out of this cycle of high inflation?
For now, Powell said that probably in the next two sessions of the FOMC, it will increase the rate target by 50 basis points at each meeting. Afterwards, rates could still increase this year by between 125 and 150 basis points. Taking into account the lag that monetary policy shows in manifesting itself in a drop in inflation, it is likely that in 2023 inflation will be around 4% per year.
If we consider the overheatingHeading 2nd of economic activity with a saturated labor market, the discussion centers on whether the Fed would go for a soft landing vs. an abrupt one of the economy (soft vs. hard landing). The orthodox would favor tightening more and maintaining an aggressive monetary policy, as they see greater long-term benefits if inflation is eradicated as soon as possible. But of course that abrupt landing would lead in the short term to a brake on the current economic expansion. So in 2023 the cycle of rate hikes would continue. If anything, it would cease in mid-2024.
Global economy: the responsibility of central banks
Many countries, both developed and emerging, used their existing fiscal space to mitigate in 2020 and part of 2021 the effect of the recession caused by the pandemic. Now, when it seemed that this was being overcome, the war between Russia and Ukraine arose unexpectedly. Most countries no longer have the possibility of fiscal buffers to absorb the effects of the economic slowdown caused by the war.
With the sharp resurgence of inflation, for many analysts the relative weight of responsibility for macroeconomic adjustment has shifted from governments (fiscal policy) to the monetary policy of central banks.
In this environment, macroeconomic policy faces serious dilemmas: balancing the control of inflation with safeguarding the recovery that requires the difficult task of rebuilding fiscal spaces without greater indebtedness.
In the order of priorities, it seems to me that it is now the turn of the responsibility of the central banks, since their success in bringing down inflation depends on preserving their credibility and a perspective of future stability. But they require governments to support their fiscal policy in the aforementioned direction. For this reason, I reiterate, a global cycle of interest rate hikes is inevitable, extending at least until 2023.
And Mexico?
The latest data on the growth of consumer prices was that of the first fortnight of April and registered a very high annual rate of 7.72% per year. This corresponded to a rate not seen since 2001. Of course, the global aggregate supply restriction conditions have affected inflation in Mexico (microchips and container costs, for example), as well as the pressures of international energy prices and the food. But unlike the United States, Mexico has a very loose and largely informal labor market, as well as stagnant economic activity, which for now is estimated at a meager GDP growth of 1.8%. So through that channel of the real economy there are no sources of transmission of inflation.
Rather, there are inflationary pressures that originate in the relative price formation mechanism, what economists call “the microeconomics of prices.” One possible source is producers and traders adjusting their prices out of line with their cost structure in an effort to quickly recoup increases they were unable to make during the pandemic, even if they are unable to maintain market share.
Similarly, restrictions on competition prevail in many markets that hinder the channel through which interest rates can affect aggregate demand and, therefore, push prices down. Finally, the T-MEC has not worked well. The competition that the T-MEC is supposed to promote and that would contribute to aligning prices internationally faces many obstacles, among others, non-compliance in many chapters by the Mexican government and distrust to invest.
In this environment of rising inflation expectations, although not as much as the Fed, the Bank of Mexico delayed the start of its restrictive monetary policy cycle and at first should have been more aggressive with the increases. Now, Banxico will surely benefit from adjusting its reference rate when the Fed does so. Most analysts consider that, on average, the reference rate could reach 8.25 or 8.50 percent by the end of the year. For this reason, it is very important in this inflationary environment that the Board of Governors of Banco de México maintain the majority criterion of a monetary policy consistent with anchoring expectations and achieving price stability in the medium term.
*The author is a Consulting Partner MAAT Asesores SC. Vice President of the Economic Studies Committee of the IMEF and member of the IMEF Indicator Committee.