The Fed and ECB Are in the Process of Changing Their Monetary Policy Objectives.
The shift from fiscal dominance to inflation control will not be without instability.
Since the subprime crisis in 2008-2009, monetary policies in OECD countries have adopted a “fiscal dominance” strategy, where fiscal policy is continuously expansionary and is not modified to stabilize the public debt ratio. It is monetary policy that is used to ensure the solvency of governments (the sustainability of public debts).
To this end, central banks have maintained long-term interest rates below the growth rates in value of the economies during the 2010 decade (which reduces the public debt ratio since public debt grows less quickly than GDP in value), and have bought public debt (this is quantitative easing) to bring down long-term interest rates further.
This policy of fiscal dominance, with interest rates remaining very low, was made possible by low inflation in the 2010s.
Even when there was a return to full employment in 2018-2019, inflation remained below the central bank's 2% inflation target, which mostly reflected the weak bargaining power of wage earners in labor markets.
Central banks have been reluctant to return to a normal organization
But the situation has become very different today. Numerous “rarities” have appeared: labor, energy, certain raw materials, and even semiconductors. This multiplicity of rarities implies the return of inflation, which exceeds 8% in the United States and the eurozone; and the return of inflation is forcing central banks to return to their previous behavior, which is to fight inflation. We can see that they are doing so reluctantly.
The Federal Reserve and the ECB have long defended the thesis that inflation is transitory, before admitting that it is permanent. The Fed now realizes that it will have to raise interest rates sharply, while the ECB has not yet done so.
Why are central banks so reluctant? From the early 1980s until 2010, they continuously pursued this anti-inflation policy, and they raised their interest rates sharply to cool down the economy whenever inflation was a threat. So to go back to this organization of monetary policy is simply to go back to the normal organization of the past.
A shift in the focus of monetary policy
But the problem is that, during the 2010s, the organization was completely different, with the adoption of fiscal dominance described above. It is important to understand the costs of the transition from fiscal dominance to inflation control.
In the fiscal dominance regime, there is no limit to the public deficit, since interest rates that are much lower than growth rates ensure the fiscal solvency of governments. In the anti-inflation regime, fiscal policy must itself ensure fiscal solvency, and countries must have a primary budget surplus (excluding interest on the public debt).
Let us show, using the example of France, the second largest economy in the eurozone, to what extent this transition will require a reduction in the public deficit. In 2022, France's total public deficit (including interest on the debt) should be around 5.5% of GDP. The primary public deficit (excluding interest due on the debt) is around 4% of GDP.
The ECB's switch to inflation control will therefore require the elimination of this primary public deficit, and thus, through public spending cuts or tax increases, the gain of 4% of GDP (100 billion euros). This is very bad news indeed at a time when we want to increase public spending on education, health, aid to industry, energy transition, defense, police, and justice ...
It is understandable that the ECB, which sees the effects of the change in the objective of monetary policy, from maintaining the solvency of States to controlling inflation, is reluctant to accept the consequences of this change of objective.
A much more unstable economy
The question then naturally arises: could central banks not return to an inflation target of 2% and accept much higher inflation (4%?) to avoid the States having to implement this budgetary contraction?
The problem is this: when inflation is 2% or less, there is no need to explicitly index wages, pensions, social benefits, tax brackets ... to prices. Since inflation is low, under-indexation does not pose many problems (for example, in the case of salaries, seniority, and individual increases are sufficient to increase purchasing power).
But if inflation is regularly 4%, it becomes necessary to index all incomes to protect purchasing power. And an economy where all incomes are indexed is much more unstable than an under-indexed economy.
A major inflationary shock (e.g. a rise in the price of oil) has its effect on inflation tripled by the perfect indexation of incomes. To avoid this instability, central bankers, therefore, prefer an under-indexed economy, and this requires that inflation be low. The Central Banks will therefore have to bring inflation down to 2% in 2024, so they will have to move from fiscal dominance to inflation control.
Some reading
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The Strong Dollar Is a Danger to the World Economy, and It Has Already Taken Its First Victims. The dollar’s rise is probably not over.
WeWork, WeCrashed, and Now (We) Flow … a New Disaster on the Horizon for Adam Neumann? Investors always prefer to believe the smooth talkers rather than focus on profitability.
The Best Business Book of All Time Dates From 1969 and Almost Nobody Knows About It. Warren Buffett and Bill Gates recommend everyone to read at least once.