Does monetary tightening tame the inflation beast?

Is economics an art or a science? In the UK, for instance, students can study for a Bachelor of Arts in economics, or a Bachelor of Science qualification. Many analysts argue that the most important distinction between an art and a science is the counterfactual.

A scientist can conduct a control experiment to see what would have happened if, for instance, the two liquids in the main experiment had not been put together. Economics – and hence policymaking – is not like that.

A central bank can claim that its rate hikes tamed inflation, but it does not know that, as it cannot say what would have happened in the absence of any rate hikes. Instead, the policymaker, and seemingly the market, just takes it at face value that it was the rate hikes that tamed inflation.

However, one thing that strikes us about inflation and rate hikes in recent years is that there has essentially been a control experiment, and it is called Japan. In spite of leaving policy rates unchanged right through to March of this year, and then only lifting them slightly, Japan’s inflation is still very modest, and this in spite of the fact that the aim of policy has been to lift inflation, unlike other G10 central banks that have been working overtime to bring inflation down.

For instance, US and Japanese CPI inflation rates are very similar today, just as they were in the early stages of the pandemic in the first half of 2020 and yet, in between times, the Fed has hiked rates 525-bps while the BoJ has done practically nothing. Can we conclude from this that US inflation would have fallen back to near-target levels even if the Fed had not hiked rates? That might seem like heresy, but it is, at least, an interesting thought experiment, and perhaps of importance when we look ahead to what the Fed and other central banks might do in the future.

Steve Barrow, Head of Standard Bank G10 Strategy doesn’t doubt that many, not just inside the Fed, would still regard this as a ridiculous suggestion. But could it be that the supply strains and energy price increases associated with the Covid shock and the Ukraine war shock that lifted inflation so much would have worked their way out ‘naturally’ and so suppressed inflation without any need for the Fed – and other G10 central banks - to lift rates, or at least not have lifted rates anything like as much as they did?

While many would argue that Japan is a poor counterfactual because its economy has been weak and policymakers have battled deflation for decades, we’d counter that the inflationary shocks, namely COVID-19 and the surge in energy prices from the war in Ukraine, impacted Japan like most everywhere else. In fact, the countries that were less impacted by the Ukraine war shock were those relatively self-sufficient in energy, like the US, not dependent on imports like Japan. In short, these were global shocks that impacted Japan at least as much as everybody else.

“We won’t know whether Japan’s atypical experience is a worthwhile counterfactual to the massive tightening of monetary policy undertaken by the Fed and others. If it is, what does it say about the stance of policy in the US and other G10 countries right now? On a simple level, it would seem to say that if these banks never needed to lift rates as much to get inflation down, then policy rates are probably much too high and market expectations for Fed cuts of nearly 250-bps over the coming year are actually too conservative, which is really saying something given that market pricing puts the Fed funds rate around 75-bp lower than the median forecast amongst economists,” said Steve Barrow.

In other words, the market may seem dovish but it might not be dovish enough. The question that remains, at least in the US, is why, if such high rates were not needed, did the economy avoid a recession? In Steve Barrow’s view, the answer to this could lie in the fact that the continuation of the massively inflated balance sheet at the Fed and ample reserves at the banks meant that policy was never really as tight as the high level of the fed funds target rate would suggest.