Speciale Financial Times

Why is central bank rhetoric hurting the global economy?

Like many parents, in the run-up to Christmas I tried to discipline misbehaving children by telling them that if they persisted they would not receive gifts.
This only worked for a short time.
My children quickly discovered that my threat was not credible.
The collateral costs of being without presents on Christmas morning were simply too great for anyone (me or Santa) to bear – and they knew it.
This is an example of what economists call a temporal coherence problem.
For a future action to be credible at the time of announcement, it must still be the smart thing to do when the time comes to act.
Even if an announced action is well intentioned – whether to discipline misbehaving children or to benefit financial markets – it will lack credibility and prove ineffective unless it actually makes sense to pursue it.
Central banks faced an acute form of this time coherence problem in the years preceding the cost of living crisis.
During that period, inflation has been consistently below its target in the United States, the eurozone and elsewhere.
Academics and politicians debated the merits of a monetary strategy that aimed to persuade markets that policy would be eased for a longer period, allowing inflation to exceed its target.
Indeed, the Federal Reserve in the United States and the Bank of Japan have announced monetary policy strategies intended to do just this.
Whether by design or (much more likely) by accident, a number of central banks have recently ended up realizing these ambitions.
Over the past 18 months, inflation has exceeded its target rate much more significantly and consistently than was ever planned.
But with global inflation falling and the economic outlook worsening, central banks are facing the opposite dilemma.
How do we discipline markets into believing that policy will remain tighter for longer in order to lower inflation to target and repair the damaged credibility of central banks? Central banks have so far used forward guidance, with a preference for future tightening, to achieve this disciplining effect.
And for a brief period over the summer, this appeared to be working, with interest rate expectations suggesting that hikes were more likely than not in the US, UK and eurozone over the course of 2024, and with no cuts of expected rates until 2025 at the earliest.
But, like my attempts with my children, the effects of these so-called operations were short-lived.
While long-term tighter central bank rhetoric remains largely unchanged, financial markets now expect significant rate cuts in the US, Eurozone and UK during the first half of 2024.
Forward guidance from central banks the markets lacked credibility for the same reason mine did: they have no temporal coherence given the probable economic reality of the moment.
Over the past three months, we have observed a clear tilt in the balance between risks to inflation and growth in major economies over the course of 2024, with both inflation and economic activity falling short of expectations.
The hope for economic growth in 2023 was that, with wage inflation starting to outpace price inflation in most countries, household purchasing power would start to recover from the blow, spurring spending in the second mid-2023 and beyond.
But add to that four powerful economic headwinds, the strength of which will only increase in 2024.
First, while real wages may now be rising, the purchasing power of most households is still substantially lower than before the cost of living crisis.
In the UK, real household incomes are not expected to recover until 2027.
Second, both households and businesses have supplemented private incomes during the recent crisis by withdrawing savings, often accumulated involuntarily during the pandemic.
That pool of savings has now largely evaporated.
Third and fourth, and unlike in the recent past, neither monetary nor fiscal policies are likely to provide relief to forward-looking families and businesses – more likely the opposite.
As for monetary policy, most of the 4-5 percentage point interest rate increase will still have to hit household and corporate balance sheets.
As for fiscal policy, after the dramatic expansion of recent years, a slowdown is likely to begin next year and strengthen thereafter.
All of this puts the balance of risks to growth decidedly to the downside.
By early 2024, inflation is likely no longer public enemy number one.
It will be replaced by rising unemployment, declining confidence and spending, and financial distress among a growing number of businesses and households.
As the economy weakens, central bank rhetoric will also slow down.
In 2014, a British politician called Mark Carney – then governor of the Bank of England – an “unreliable boyfriend” because he said one thing and did another.
The world's central banks now risk a similar fate.
For all their protests, central banks around the world will offer interest rate gifts to the masses throughout 2024.
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