Monetary Policy Gets Complicated

Making monetary policy in a 20-country union was never going to be easy. And coming out of a global pandemic was not going to make it any easier. But the problems faced by the ECB, the Bank of England, the Federal Reserve and others have common roots linked to polices to deal with the Covid crisis, the impact of Covid on global output, trade, and supply chains, the war in Ukraine and the elevated rate of inflation that has left most major money center countries with inflation above their respective targets.

In this situation, central banks have been trying to find the sweet spot for policy. Central bankers have been missing their inflation targets for three years - consistently. And while the Covid crisis disrupted growth and elevated unemployment (some places much more than others). Unemployment rates have returned to their pre-Covid lows or better, and yet inflation is still above target. In the 1980s and 1990s, we know what central banks would have done but these central banks are not those central banks. The names are the same, but the policies have been shifted to reflect different policy priorities.

EMU The euro area is a good example of all this; inflation has been over target since 2021 and the unemployment rate in the euro area has never been lower. And yet, this week, the ECB moved to cut rates. It did this even has the ECB shifted its inflation outlook higher at the current meeting. It is hard to say what analysis underlies this policy choice. The stated goal was to support the economy; at its meeting Christine Lagarde did not at all sound like she was planning a series of rate reductions. But the fact of the rate cut cannot be reassuring to those looking for the ECB to be the torchbearer for European monetary policy austerity.

GDP growth in the euro area solidified in Q1 but the year-on-year pace is still quite weak. Among the 12-EMU members reporting in the table in Q1, only the Netherlands reported a quarter-to-quarter GDP decline. However, Austria, Finland, Germany, Ireland, Luxembourg, and the Netherlands (six countries) log year-on-year GDP declines in 2024-Q1. Six member countries showed GDP declines year-over-year in 2023-Q4; six also show GDP falling in 2023-Q3; five GDP drops are counted in 2023-Q2. There is no arguing with the notion that growth in EMU is weak. But is it- was it- threatened in a way that a single 25bp rate cut alleviated risk? Did an isolated rate cut have any role to play at all in macroeconomic policy? What was the ECB trying to tell us with that cut?

Ranking growth rates for the 12 countries in the table shows only Greece with a year-on-year growth rate above its median growth pace on data since 1997. Globally, growth is weak- the U.S. is a notable exception; and yet as the year began, the Fed in the U.S. was preparing for as many as 3 rate cuts this year! Something at central banks has shifted. But inflation risks seem to have shifted too and for the worse. China is no longer the low wage force it once was. The peace dividend is looking as if it has been spent. A rearmament cycle now seems more likely. Are central banks operating differently or have they gone soft? We are about to find out.