Fighting Inflation: Do the Fed and Other Central Banks Really Believe in Inflationary Risk?

Central bankers try to pull the wool over our eyes with words rather than acting on rates.

Not everyone pays close attention to the announcements of central bankers. I understand that completely. For those who would like an ultra-condensed summary of the latest statements from Fed or ECB members, it might look like this:

“Inflation is likely to wipe out everything in its path, we need to act fast and hard.”

This might scare you if you are an investor, but beware, because if we have to act fast and hard, Christine Lagarde, the head of the ECB, tells us that we should not go too fast. Overall, we got the message. The central bankers are planning more restrictive monetary policies.

However, something doesn't add up. There is a surprising disconnect between words and rates. The words used to talk about the danger of inflation are not reflected in the rates that are proposed to curb this risk. In truth, we are a long way from a monetary policy that would become restrictive. It would be more appropriate to speak of a less accommodating monetary policy.

What the Fed is doing is very telling of what central bankers are thinking right now regarding inflation

The American case is the most perfect illustration of this. Today, the Fed's key interest rate is set in a range of 0.25 to 0.5%, while inflation is expected to reach 8.5% in March 2022:

The cost of money, represented by rates, is therefore much lower than the cost of living, represented by inflation. One could anticipate that the Fed's desire to fight inflation will result in a significant rise in rates. Yes, the increase will be significant, from 0.5 to nearly 2% at the end of 2022 if we believe the expectations. The Fed could even announce a 50 basis point increase at its next FOMC meeting on May 3 and 4, 2022.

But this cost of money will remain well below the cost of living, which is expected to decelerate from 8.5% to nearly 5%. Even at its peak in 2023, the cost of money would only manage to return to the same level as inflation: 3%. This does not give the impression of a policy that is equipped to fight galloping inflation.

The reading becomes even more disturbing if one takes a closer look. Indeed, insiders are used to consulting a range of monetary policy rules proposed by academic research. These rules allow them to calibrate an appropriate level of policy interest rate to economic fundamentals, which they then compare to the prevailing policy interest rate.

If the rate required by the rule is higher than the current rate, then we say that monetary policy is too accommodating: the Fed should therefore raise its rates. We can even project the expected rate to the required rate under different economic scenarios.

The results are clear, as you can see on the Federal Reserve Bank of Cleveland's website: “Simple Monetary Policy Rules”.

Out of 21 cases (7 rules and 3 scenarios), 19 would justify a policy interest rate higher than the current 0.5% today. Over a one-year horizon, 17 out of 18 cases would justify a policy rate higher than the 2% that is planned. Finally, at a two-year horizon, 13 out of 14 cases would justify a policy rate above 3%. Monetary policy is not, and will not become, restrictive if the rates forecast by the Fed members or the markets are the ones that will be applied. The Fed will remain very accommodative. Certainly a little less than before, but still, we would be far from the announced tightening cycle that has all markets shaking.

The ECB is not to be outdone. Admittedly, its inflation level is a little below that of the United States at 7.4%. But the ECB is not planning to raise its rates as hard and as fast as the Fed. Only a rate hike of 0 to 0.25% would be considered by the majority of the members by the end of the year. This is a far cry from the Fed's 2%. We can then proceed with the same type of analysis as for the Fed above. The result will be the same: the ECB will not have a restrictive monetary policy either in 2022 or in 2023, but a slightly less accommodating policy.

Monetary Mannerism

But then why such verbal aggression from central bankers, for a monetary policy that is just less accommodating?

The first explanation that comes to mind is that they don't believe what they are saying. The inflationary risk is oversold. No one believes that this galloping inflation, boosted by the repeated confinements and the Ukrainian conflict, will ever stop wages. No one believes in the second-round effects on the overall prices of goods and services.

Even the bond markets don't believe in it. Frankly, with 10-year interest rates at nearly 3% in the US and 1% in Germany, while inflation is at 8.5% and 7.4%, can we talk about a bond crash?

The rise in interest rates since the beginning of the year is impressive, sharp, and rapid, no doubt. But we are closer to allegretto than allegro. Certainly, the story is not over.

More likely, central bankers still do not recognize the inflationary risk. Inwardly, they remain convinced that inflation will fall like a bellows, and that restrictive monetary policy should be avoided at all costs. Economic activity would not withstand it, and the markets would not survive it.

For the past 15 years, successive crises (subprime, sovereign debt, Covid-19) have made economic and financial performance far too dependent on a monetary policy that became ultra-accommodating without ever generating undesirable price pressures. This can be seen in all the so-called developed economies. An analogy with the addiction phases of a drug addict allows us to better understand the current behavior of the markets.

Convinced that this period was marked by the seal of excellence in terms of monetary policy, central bankers refuse to believe that it can end so stupidly. So Central bankers try to pull the wool over our eyes with words rather than acting on rates. They exaggerate the word rather than the deed. This kind of practice was also known in art in the 16th century: it was called Mannerism.

The expression of a current that sought its voice after the leading artists of the time (16th century) had reached perfection. Rather than risking leaving the intoxication of genius, they preferred to move away from it a little, exaggerating the features, the figures, the motifs. In short, exuberance rather than diagnostic wandering.