“The world of central banking and modern global finance has been evolving in ways previously unimaginable. It has now entered a new phase of increasing artificiality and distortions”.
Mohamed El Erian, The Only Game in Town.
After several decades of relative price stability, inflation has picked up unexpectedly around the world under the largely complacent gaze of many central banks. Today there are serious discussions about the causes of the inflationary rebound and the appropriate response of the monetary politics, which has the officers responsible for it in a complex situation, especially since there is no consensus on the proper course of action. It seems timely then to address the issue and share some reflections on these issues that will have great relevance on the economic and financial outlook.
Monetary Policy Basics
We start by doing a quick review of the most basic topics of the monetary politicsto separate the things we know from those we suspect or imagine, and trying to simplify to the extreme.
For the proper functioning of an economy, it is necessary to have a commodity that serves to cover certain basic functions, especially serving as a unit of account, means of payment and a store of value. In previous centuries, the goods that served as money had an intrinsic value that guaranteed the function of being a store of value, but in today’s world, money is 100% fiduciary, since banknotes and coins do not have an intrinsic value that corresponds to the nominative value established in them.
Money is basically printed paper with special symbols that give it the “magic” of being generally accepted and used to carry out transactions or pay off debts. These symbols make it possible to know who the issuing entity is, in this case, a central bank, and in some way convey to the bearers the credibility of the issuer of the note and the value it confers. Some central banks, such as the United States Federal Reservehave high credibility, since over many years they have managed to maintain the stability of the purchasing power of the money they issue.
In today’s world, central banks they are the only ones who can print money in their respective countries, completely controlling the money supply. This function has to be done carefully to preserve the value of money, since, like any commodity, the price of money reacts to changes in supply and demand. If supply exceeds demand, the price falls and vice versa. The price of money is the interest rate at which it can be lent or borrowed. By controlling the quantity of money, central banks largely determine interest rates.
A major question for central banks is what is the appropriate amount of money for the economy and, therefore, what is the appropriate level for the interest rate. Usually, if the economy does not have enough money to be able to carry out all the transactions that are desired, then economic activity is limited in some way. On the contrary, when there is too much money in circulation, price pressures are generated as the economy “overheats”, which is what happens when the demand for goods and services exceeds the available supply of them.
Although it is clear that there is a relationship between monetary conditions (amount of money in circulation and interest rate) and the pace of economic activity and price dynamics, it is not at all easy to identify what is the appropriate level of money in circulation. and interest rates, since the economy is changing all the time and being affected by various shocks.
Another especially important consideration is that the interest rate is one of the key prices in an economy, since it influences a large number of decisions made by economic agents. Households, for example, can change their consumption and saving patterns; or companies may change their investment patterns or balance sheet composition based on the interest rates they observe. From this it can be concluded that, if the interest rate is at a level that does not correctly reflect the fundamental situation of an economy, such as the amount of savings available or the long-term perspectives of companies, then the decision is encouraged. of bad decisions by economic agents, that is, distortions in the functioning of the economy.
To turn around the problem of determining the appropriate monetary conditions, central banks have used for several years, and with great success, the inflation targeting scheme, which basically consists of making public an inflation level that the bank The central bank undertakes to maintain over time, and for this it adjusts monetary conditions by restricting liquidity and raising its interest rate when inflation is above its target, and relaxing liquidity and lowering the interest rate when inflation is above its target. below the target.
A special problem facing the conduct of monetary policy is the lag that exists between the changes made to monetary conditions and their impact on the economy, especially on inflation levels. This implies that you have to look into the future, over relatively long horizons ranging from three months to two years, to consider the effects of changes in monetary stance. For this reason, expectations play a very important role in the conduct of monetary policy, both the expectations of the central banks themselves and of the general public.
Different types of expectations
Here it is useful to distinguish the type of expectations, especially among those of the public, that correspond to the companies that make pricing decisions; to the expectations that are collected in surveys among economic analysts, and to the expectations that investors participating in the financial market have.
Although the expectations of economic analysts are the most well-founded forecasts of inflation, they are not subject to limitations and biases that can generate a certain “rigidity” in the forecasts that distance them from reality. On the one hand, analysts employed by institutions, mainly financial ones, have limited resources that restrict the robustness of the econometric models used for forecasting.
On the other hand, there is an inherent “discipline” in the market that inhibits significant deviations from the average, since when someone has a forecast that is very different from the market average, it is questioned and frequently put in doubt. Perhaps that is why the famous economist John Kenneth Galbraith said that “it is much safer to be wrong with others than to be the only one right”. These limitations mean that these forecasts are relatively slow moving and focused on the short term. Today, the medium- and long-term inflation forecasts of economic analysts have moved very little despite the rise in inflation, which seems to me to be explained more by the limitations that we have mentioned than by the confidence they may have in the inflation quickly returns to lower levels.
On the other hand, there are the expectations of investors who make decisions to buy and sell financial assets based on their expectations.
This is especially relevant for the long-term bond market, which incorporates investors’ expectations of inflation. If the central bank allows its credibility to deteriorate by allowing higher than target inflation levels for longer than is acceptable; then, investors begin to incorporate higher long-term inflation expectations, and consequently demand higher premiums for this inflation, which results in higher long-term interest rates. It should be noted that these rates are the ones that best reflect financing costs and affect companies’ investment plans.
The resurgence of inflation
Both in Mexico and in the United States a breaking point can be seen in February 2021, since until this month inflation could be considered to be within the usual, but as of March it begins to increase strongly, especially in the United States. United States, reaching a level of 8.54% in March 2022, the highest in four decades.
Although it is true that inflation in the world has been responding to various shocks, mainly supply shocks, such as the disruptions generated in supply chains by the confinements generated by the pandemic, it is necessary to note the role that politics has played economy, mainly in the United States.
In March, a very unfortunate statement was made by the president of the Federal ReserveJerome Powell, in the sense that they would not act preventively based on forecasts, perhaps giving a signal of “complacency” with inflation that helped trigger the increase in prices
Throughout 2021, it was discussed whether the rise observed in inflation had a temporary or more permanent nature, and for much of the year, the Federal Reserve took refuge in the idea that the upturn would be transitory, so that it was not necessary to adjust the monetary stance. Already in 2022, the Russian invasion of Ukraine added another unforeseen shock to the economic environment and further complicated the inflationary outlook.
The Outlook for Inflation and Monetary Policy
Regardless of the causes that have originated it, the fact is that inflation has rebounded throughout the world in a way not seen in decades, and has made the action of central banks with their monetary policy inescapable. The Federal Reserve It has had to significantly adjust its speech and has had to take action, beginning a cycle of raising the reference interest rate and making, in its most recent decision, an increase of 50 base points that has not been seen since 1994.
The problem for Federal Reserveand other central banks including our Bank of Mexico, is that they are already late in the fight against inflation, because as we already mentioned, monetary policy acts with a significant lag on the economy. To date, there is still an intense discussion in the media and in the markets about what central banks should do, since many analysts point out that the increase in interest rates does not represent a solution to supply disruptions, but it can put the reactivation of the economy at risk and even generate a recession. What is lost in these comments is that a truly restrictive monetary policy is required not to stop inflation this year, but the next five.
The key point that central banks have to ensure is that the expectations of medium and long term inflation, especially from the public and investors, remain well anchored, which will only happen if they see central banks acting with appropriate firmness. If the economy of the United States or of other countries enters a recession, that would not necessarily be “the fault” of the restrictive monetary policy, but rather of the distortions that accumulated after several years of an excessively loose monetary policy, coupled with other various factors. But that is another story to be told another time.
* The author is ANDIndependent economist, president of the Economic Studies Committee of the IMEF, member of the IMEF Indicator Committee. Founder of the Youtube channel Economy in Brief.