Prevention is better than cure. But, first and foremost, do no harm. These basic, ancient medical precepts resonate in the minds of central bankers as they prepare to make the most difficult decisions of the last five years.
La European Central Bank will meet next Wednesday and Thursday and will communicate its choice on June 11th. US Fed will deliberate and announce the outcome of its meeting on Wednesday 17th. The Bank of England will do it on the 18th and the Bank of Japan On the 15th and 16th. The question of whether to raise interest rates, and by how much, in the face of a new surge in inflation, is on the table. Remember the lesson learned from the previous surge in consumer prices, when monetary policymakers long viewed the acceleration as temporary and waited for it to subside on its own, only to then have to rapidly and substantially raise interest rates.
The markets have already "voted" their way, pricing in one or more 0,25 percentage point rate hikes from all central banks. And while for the Bank of Japan, the choice is almost obvious, as well as announced, given that its tiller is still at 0,75%, overall inflation is at 1,3%, core inflation (excluding fresh food and energy) is at 1,9%, and the yield on ten-year government bonds is at 2,66%, for the other three, anything, or almost anything, can still happen, even if for the ECB, the balance is tipped toward a hike of a quarter (not a quarter of a pound!).
On the other hand, markets vote every day and are quick to change their minds. For example, before the war, they expected two rate cuts from the Bank of England, and afterward, they even anticipated three hikes, with a swing of 1,25 percentage points. And no one asks them to account for the many predictions they made in the past that didn't materialize.
Economists, on the other hand, once they take a position, they stick to it, as if it were the Maginot Line (which, we know, ended up in World War II). In this case, they almost unanimously stated that interest rates must be raised to avoid repeating the same misjudgment as in 2021-22.
The reference to the fortified defensive line built by France between 1929 and 1938 along the borders with Luxembourg, Germany, and Italy (in theory, it should have extended to the North Sea, but Belgium offered guarantees of neutrality, only to prove to be the line's Achilles' heel) reminds us of another ancient warning, this time of military origin: generals fight the new war with the strategy learned in the previous one. For example, the First World War was one of positioning and trenches, and the Maginot Line was inspired by that method of warfare. But the Second World War, with new transport technologies "by land, sea, and air" (as the late M. put it), was essentially one of movement or "lightning" (as the even less late H. put it). And, in the most recent wars—Ukraine and Iran—generals seem to have underestimated the effectiveness of the massive use of drones…
Central bankers today risk appearing like the proverbial generals. Because current conditions are vastly different from those of four or five years ago, except for one thing: the supply shock. Now, as then, there is a sharp increase in the cost of raw materials, especially energy, and transportation, and there is a shortage of components. But the origin of this commonality is different: then it was the uncoordinated anti-Covid policies between nations and continents in their openings and closures (after all, each had to deal with its own epidemic waves and its own means to combat them). Today, it is the closure of the Strait of Hormuz, and everyone knows the cause, and everyone can use their favorite adjective to describe the Trump Administration's actions against Iran.
But the similarities end there, and the differences are preponderant and powerful, and thus the consequences of the supply shock. The differences lie both in the economic framework and in the stance of economic policies. Let's begin with the latter, which is easier to illustrate.
In 2020-2022 public budget policies (the English say fiscal policy(and Italians mistranslate it as fiscal policies) and monetary policies were hyper-expansionary. They were so partly as a legacy of the experiences with the measures adopted to counter the Great Financial Crisis (2007-2009), when deflation in private debt and prices prevailed, and partly to alleviate the pain caused by the pandemic. These pains were human, not just economic, although at times the diaphragm separating one from the other is thin. Today, fiscal policies are neutral or restrictive, and the same can be said for monetary policies, with the exception of Japan.
The key measure for understanding whether and to what extent a fiscal policy is expansionary or restrictive is the change (not the level) in the structural balance, i.e., net of the effects of the economic cycle on public revenue and expenditure. In 2020, the structural balance worsened by three percentage points of GDP in the Eurozone, by nearly five percentage points in Japan, and by approximately 7,5 percentage points in the UK. That is, those economies received a powerful boost; however, that boost wasn't immediately visible in GDP for the simple reason that the lockdown prevented consumption and production of most services. Thus, the injection of public money translated into savings for households, which they later converted into purchases, and into oxygen for businesses to survive until reopening. In 2021, both the US and the Eurozone provided a further small boost, while the UK and Japan slowed (reducing the structural balance). This slowdown became significant in the US itself in 2022, mild in the Eurozone, and continued sharply in the other two economies.
However, in that case, it's inappropriate to speak of a real slowdown. Indeed, returning to the initial medical metaphor, once the lockdowns were over and the mass vaccination of the population against the virus began, the patient-economy had begun to walk on its own two feet again and could leave the intensive care unit to which it had been subjected. It was therefore normal for structural deficits to decline, without thereby slowing anything down. Furthermore, the economic system still had ample reserves (excess savings) of spending potential that could give free rein to the pent-up desire to travel, attend events and shows, eat out, and so on. In other words, although the statistics suggest a budgetary tightening was underway, the expansion implemented in 2020-21 was in fact a delayed reaction, or rather, its effects were spread out over time.
An example of excess savings is the American one, calculated by us. By saving, saving, not by spontaneous decision but by health constraint and in the face of generous federal transfers, by mid-2021 US consumers had set aside the equivalent of almost two months' worth of spending (182% of monthly spending). A real "treasure trove", which they then gradually consumed (nomen omen) in the following years. Calculations carried out for other economies, including Italy, yield similar results in terms of quality, though not in terms of size.
Currently, fiscal policy is neutral or slightly restrictive, always measured against the change in the structural balance. This is even more true if we were to use the primary structural balance, i.e., net of interest expenditure, because the burden of financial costs on public budgets has been growing along with sovereign debt. Therefore, while fiscal policy was inflationary in 2020-22, it will not be so in 2026.
Monetary policy was also hyper-expansionary at the time, perhaps even more so. Whichever measure was used, there was no doubt. Central banks' interest rates were zero or even negative (this was the case with the ECB and the Bank of Japan). Ten-year government bond yields were extremely low, thanks in part to the central banks' massive purchases, which thus inflated their balance sheets (Quantitative Easing).
Central banks are currently maintaining neutral (ECB) or slightly restrictive (Fed, Bank of England) rates; only the Bank of Japan's rates can still be considered expansionary, but they are normalizing. Long-term rates are consistent with healthy economies and appropriate for the expectation of a rapid reduction in inflationary pressures caused by the US-Iran war. Central bank balance sheets are either shrinking (Quantitative Tightening) or stable at levels already significantly reduced from their peaks.
Thus, neither fiscal nor monetary policies are currently as inflationary as they were in 2020-22; if anything, they are slightly deflationary.
Above all, the conditions of economic systems are very different. Here we limit ourselves to considering two dimensions: household consumption and the labor market, both of which are fundamental as driving factors (pull) and thrust (push) of inflation.
In 2020-22, consumption was rising sharply, like a two-stage rocket. The first stage was driven by demand for manufactured goods: since people could barely leave their homes, spending impulses were channeled into the purchase of material goods, which are more likely to drive international trade and thus exacerbate bottlenecks in global value chains. In the second stage, however, the free-for-all afforded by vaccinations allowed people to resume travel and participate in social life, with the associated boom in services.
Today, however, services, especially those related to international travel and sold to consumers, have been hit hard by the Persian Gulf crisis. On the other hand, manufacturing is holding up, not because there is strong final demand but because all companies have adopted the strategy. just-in-case, filling warehouses with raw materials and semi-finished products to avoid the shortages and price increases experienced in 2020-22; but this increase in demand is short-lived, because once warehouses are filled, it runs out. Therefore, consumption is slowing, not increasing as it was four or five years ago. Therefore, there is no buffer for inflation, precisely because the supply shock has reduced households' purchasing power.
Nor is there any pressure on wages on the cost front, as there was last time. Indeed, labor market conditions have changed significantly since then. It's true that the unemployment rate remains low, but the ratio between labor demand (by businesses) and labor supply (by people) has also normalized. Explaining the whys and wherefores of this ratio's surge in the immediate post-pandemic period would require another article. The fact is that wages accelerated sharply back then, while now they have slowed and continue to slow, and this contributes to diluting the cost pressure from raw materials.
Given these vast differences between current and past conditions, central bankers could easily remain wait-and-see this time. Instead, they're struggling to decide whether to raise interest rates, and by how much. Why? For fear of repeating the mistake of underestimating them last time, and being put on trial and losing credibility. In a world so disrespectful of rules and institutions, nothing could be easier. Thus, like the generals mentioned at the beginning, it's very likely they'll make another mistake, but one of the opposite nature. And they'll be equally criticized.
