It’s time to hasten slowly as rate cycle nears its end

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Massive supply chain disruptions that collided with surges in demand from households suddenly showered with government cash and experiencing near-zero borrowing costs ignited inflation rates that had been dormant for decades.

Global supply chains may now be functioning relatively normally, but they are changing amid the tensions between the US and its allies and China, the war in Ukraine and the lessons learned about the vulnerabilities created by over-reliance on global supply chains during the pandemic.

The restructuring of those supply chains, the push for re-shoring and friend-shoring of strategic production, will raise costs and have a continuing impact on inflation rates.

In that sense, the Fed and its peers are pushing against a tide that contains some unconventional factors. This not a conventional inflation cycle because it reflects, to some degree, structural changes occurring within the global economy that will play out over years, if not decades.

It’s also abnormal because, despite the rate at which the Fed and other major central banks have tightened their monetary settings, unemployment rates remain at or near historic lows, and the US economy has proved to be far more resilient in the face of the rate rises than expected.

‘Earlier in the process, speed was very important. It is not very important now.’

Fed chair Jerome Powell

Sharemarkets, which ought to be rate-sensitive, have been on a tear over the past nine months despite the Fed and despite a surge in bond yields.

The big technology stocks, which ought to be the most rate sensitive, have led the charge, with the NYFANG index that includes all the US tech heavyweights rising about 70 per cent this year, heralding what might be another, AI-driven wave of economic change. Corporate earnings in the US and elsewhere are generally surprising on the upside.

The tools available to central banks are crude. They can raise the cost of borrowing and influence the amount of liquidity flowing within their financial systems.

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There’s no doubt that, if they want to drive the inflation rate down to 2 per cent (in the Reserve Bank’s case, within a range of 2 to 3 per cent over time), they can.

However, given the economic conditions in the settings in the US and countries like Australia, that would come at a heavy cost in the form of household and business financial stress and distress, and a big spike in unemployment.

Arbitrary targets

The central banks’ targets are arbitrary. There’s no science to them, just a gut feel that 2 per cent, or the RBA’s 2 to 3 per cent range, is about right based on the central banks’ historical experiences.

When Paul Volker retired as the Fed’s governor in 1987 and was hailed as the man who broke the back of the last bout of ultra-high price growth, inflation in the US was around 4 per cent and no-one saw that as a threat.

It makes some sense for the Fed and other central banks to do what the Fed did last week and pause while waiting for more data.

There are long lags between central banks’ actions and their effects on real economies. It is only with hindsight – a year or 18 months later – that their success, or failure, can be evaluated.

Given how volatile, complex and largely unprecedented in the post-World War II environment today’s global economic and geopolitical circumstances are, hastening slowly makes even more sense.

It is conceivable, though probably unlikely, that the Fed and its peers have already done enough to bring their inflation rates down to acceptable levels (if not to their targets) without forcing their economies into unnecessary and avoidable recessions.

While the risks of inflation rates that are entrenched at unpalatably high levels are such that central banks will always err on the conservative side, the costs of over-kill are also significant. They shape people’s lives, and not in a good way.

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Powell said that the two rate rises pencilled into its Open Market Committee members’ “dot plot,” or projections, last week were a “pretty good guess of what will happen” if the US economy evolves as they expect. Those members, and the financial markets, also expect rates to be falling next year.

Given that all the major central banks got it wrong during the pandemic when they believed the surge in inflation was “transitory,” those expectations have less credibility than they might once have had.

Whether they get it wrong by doing too much and inflicting avoidable damage on their economies, or too little and are forced to cause even more pain than they currently envisage, is, of course, the multi-trillion dollar question yet to be answered.

The probability of the central banks getting monetary policy perfectly right is, however, unlikely given their track records and the nature of the policy tools they have at their disposal.

Powell was right when he said that now speed is less important than the level to which rates are raised. What that level should be, however, remains an open – and for many threatening – question. Hopefully, the central bankers will err on the right side of caution.

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