The US Fed and the ECB are under pressure to lower inflation

Global bond and stock markets have been particularly volatile in recent weeks as general divestments, which began at the beginning of the year, intensified as macroeconomic prospects worsened. The main reason for these movements was the many negative impressions that came from the inflation indices in the main developed economies. In fact, the overall consumer price index (CPI) for the US and the euro area rose again in May 2022. By 8.6% for the US and 8.1% for the euro area, CPI figures were well above the 2% target set by their respective monetary authorities.

It is important to note that the inflation indices for the month of May were significantly higher than what politicians and investors had expected. This was especially true in the United States, where the “peak inflation” debate gained ground ahead of the release of the new indicators.

Inflation and key interest rates in the United States

(year / year,%, 1970-2022)

Sources: Gardens, QNB analysis

Higher-than-expected inflation has put pressure on the US Federal Reserve (Fed) and the European Central Bank (ECB) to abandon their overly dubious stance and accelerate the pace of monetary policy normalization.

This article examines the challenges that the Fed and the ECB have faced in recent months.

In the US, the Fed is “late on the curve” and needs to tighten its policy rates faster to curb inflation. The last time US inflation peaked in May 2022 was in early 1982, when the Fed’s key interest rate was 15%, down from its current level of 1.75%. It used to be that every time US inflation broke the 5% limit, the price spiral problem was not brought under control until political interest rates were raised aggressively to at least as high as inflation. Each time this has happened, monetary tightening has contributed to a recession.

This time, it seems extremely unlikely that US policy rates will exceed existing inflation rates. Due to the total level of debt in the US public and private sectors, which is around $ 85 trillion, or 350% of GDP, it would be very difficult for the Fed to keep key interest rates well above 3, 5% or 4% . This would increase the debt burden too quickly, increasing the risk of a financial crisis or a sudden stop in consumption and investment. Thus, if inflation does not decline over the next few months, the Fed will face difficult choices about which aspect of its mandate to focus on – price stability, full employment or financial stability. This may be one of the toughest arbitrations in Fed history.

Inflation rates and historical policy rates in Germany

(year / year,%, 1970-2022)

Sources: Gardens, QNB analysis

In the euro area, the ECB’s policy choices are just as difficult. After several quarters of dizziness with the deflationary effect of the pandemic, prices rose sharply in the second half of 2021, which surprised most analysts and investors. In fact, it has become the most severe inflation shock the eurozone has ever experienced in more than twenty – three years of history. If we take Germany as an indicator of inflation in the region before the introduction of the euro, the last time inflation reached its peak was in May 2022. 1973, when the Bundesbank’s key interest rate was 7%. The ECB’s current key interest rate is -0.5%. The negative gap between inflation and key interest rates is several times greater than anything else in the last two decades, which means that the ECB has a lot to “catch up” in terms of interest rate hikes, especially as a growing interest rate differential with the US will put increased pressure on the euro. . Without a significant cycle of ECB rate hikes, the euro could fall further against the dollar, increasing inflationary pressures due to rising costs of imported goods.

However, monetary tightening in the eurozone could be costly. The macroeconomic situation differs between euro area countries, in particular in terms of employment rates, budgetary requirements and debt levels. The southern Mediterranean countries or the “periphery” of the eurozone, such as Greece, Spain and Italy, have higher unemployment, budget deficits and debt levels than stronger economies in the Nordic countries (Germany, Austria, Belgium and the Netherlands). Southern European economies are therefore more vulnerable to a hawkish turnaround from the ECB. If this trend continues, higher interest rates could cause a new regional debt crisis in the “periphery” of the euro area. This problem may be exacerbated by the escalation of the conflict with Russia, which could lead to a severe energy shortage in some Western European countries, which could lead to a sudden halt in production activity.

Overall, both the Fed and the ECB are under pressure to lower inflation within their mandate. If inflation does not decline markedly over the next few months, this risks confirming the situation and creating the most difficult monetary policy environment since the “stagflation period” of the 1970s.

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