The writer is the chief executive of Lazard Financial Advisory
Are interest rate rises more like antibiotics or steroids? Former US Treasury secretary Lawrence Summers thinks the former; I’d say the latter. And the answer matters, because it should determine whether the Federal Reserve and the European Central Bank now pause their current tightening cycles.
With antibiotics, it’s better to take all your medicine even if you’re already feeling better after a couple of days. As for corticosteroids, when used in moderation they can reduce inflammation and control reactions — but take too much or for too long and you can risk the whole immune system.
And therein lies the principal dilemma for central banks. Reasonable estimates suggest that most of the economic impact of the Fed’s rate rises has yet to be fully felt.
This dilemma is complicated by three factors. First, both the Fed and the ECB were too slow in shifting to tightening. So, understandably, they now have the zeal of the converted and may well overdo what is necessary to prove their newfound toughness. However, they need to weigh not only the real economic damage that would come from oversteering but also the threat to their credibility from having to reverse course next year.
Which brings us to the second and more important complication: heightened uncertainty surrounding the inflationary process. In the US, we have now had two encouraging consumer price reports in a row. The prices of many consumer goods are falling in absolute terms. Freight rates have come down by more than 90 per cent for some vessels and factory lead times are starting to shrink. The official figures also remain mechanically elevated by current rents, and this component will bring the inflation numbers down in the future.
The biggest concern is wage pressure, which has admittedly not yet abated but which should eventually be affected by declining job openings. In any case, recent research, including from the IMF, suggests that the risk of so called wage-price spirals that could entrench inflation may be lower than previously thought.
In Europe, the drivers of inflation differ but the conclusion is similar. A larger share of overall inflation in Europe is being caused by energy and food prices, which are harder to tame with monetary policy. So pausing the tightening cycle makes even more sense for the ECB than the Fed. Yet central banks across the world, including the Fed and ECB, continue to push ahead on rate rises, including through their actions this week, and promise more in the future.
In this context, the risk of overdoing things through both additional interest rate increases and ongoing quantitative tightening is significant. Financial conditions have tightened appreciably over the course of this year. Stress measures that incorporate the impact of dollar strength are close to peaks from previous crises.
If either the US or eurozone enters recession in 2023, the scope for fiscal policy relief will be limited at best. The result would be pressure on central banks to reverse their tightening — though ironically the impact of such a reversal would come too late to do much good. Rather than going up and then down, isn’t it better to pause and see what is necessary?
The third complication is the US government debt limit and its attendant risks to financial markets. The leadership of the incoming House of Representatives has vowed to use the debt limit as leverage to demand spending cuts and other concessions that will probably prove unacceptable to the Biden administration. Heightened uncertainty over the debt limit, in conjunction with reduced liquidity in the Treasury market, should make the Fed more cautious about the path ahead.
Despite these considerations, some would argue that a pause is dangerous, because neither the Fed nor the ECB can risk falling behind inflation and ending up in a situation analogous to the 1970s, when inflation became entrenched. But pausing the cycle of tightening until we have a better sense of the impact from what’s been done to date doesn’t preclude doing more later if necessary. And unlike in the 1970s, inflationary expectations have remained remarkably anchored to date.
There is no doubt that central banks face difficult choices. But it is much better for them to tighten less and wait for their prior decisions to hit, than over-tighten and bear the economic costs of doing so. Sometimes the best course of action is to wait and see. This is one of those moments. Unless new evidence arises that inflation is picking back up, central banks should pause for three to six months and then evaluate the state of the economy.
