Central banks have the last laugh: Inflation tamed without a recession

The world economy will grow at 3.2 per cent in 2024 and 2025, says the International Monetary Fund’s (IMF’s) latest Economic Outlook. That is below the 3.6 per cent growth rate seen during 2006-15. Yet, the relief over the growth projections is almost palpable. 

There is relief because the battle against record levels of global inflation has been won — or so the IMF declares — without as much loss of growth as was feared. Inflation rates are trending down without the global economy going into recession.  Commentators who had been critical of central banks’ responses to post-Covid inflation have been proved wrong.   

Global inflation peaked at 9.4 per cent year-over-year in the third quarter of 2022. In the US, the inflation rate rose to 9.1 per cent in June 2022. Since then, inflation rates have been dropping. Global headline inflation is now projected to reach 3.5 per cent by the end of 2025,   below the average level of 3.6 per cent between 2000 and 2019.  

As inflation started surging after the Covid-19 pandemic, central banks were roundly criticised for tightening too little and too late. Since central banks were slow to react, critics said, monetary tightening would have to be extremely aggressive. A soft landing was almost impossible.   

Central banks have also been faulted for being slow to loosen monetary policy when the inflation rate began to decline, and growth was seen to be faltering. Might they have done anything differently? Since the actions of central banks were broadly synchronised, let us focus on the actions of the US Federal Reserve. 

The pandemic was correctly seen as giving rise to a supply shock as well as a demand shock.  Monetary (and fiscal) policies to boost demand were entirely appropriate. Expansionary policy caused the inflation rate in the US to rise above the target rate of 2 per cent in March 2021.  

Once the pandemic-induced restrictions were progressively removed through the second half of 2021, producers found it difficult to ramp up output due to supply chain disruptions. Demand ran ahead of supply, the US inflation rate surged. There was an expectation that as supply bottlenecks eased, inflation would come under control. In any case, the Fed could not have been expected to tighten policy when the pandemic was still raging. 

By December 2021, the inflation rate in the US had touched 7 per cent. Just as central banks were preparing to tighten policy in early 2022, there came another shock — the onset of conflict in Ukraine in February that year. Oil prices rose sharply amid expectations that the oil market would be severely disrupted. Inflation in the US shot up to 7.9 per cent in February. By mid-2022, global inflation had tripled relative to its pre-pandemic level.  

The Fed commenced tightening from mid-March 2022, with a 25 basis points (bps) increase in the policy rate. By June 2022, the policy rate in the US had jumped by 150 bps. By July 2023, the rate had gone up by more than five percentage points.  Should the Fed and other central banks have tightened even more and even earlier in response to the Ukraine conflict? 

The short answer is that central banks’ responses to such events can only be tentative.  Could anybody have imagined that the conflict in Ukraine would go on for over two years? And that, two years into the conflict, oil prices would be contained at below $80 a barrel, thanks in part to the European Union/ North Atlantic Treaty Organization-imposed price cap on oil imports from Russia? How much to tighten monetary policy and at what pace in response to such events can only remain in the realm of guesswork. 

Suppose the Fed had indeed tightened earlier. What might have happened? The IMF’s Outlook uses a model to examine the outcomes had the Fed tightened three quarters earlier than observed. It finds that peak inflation would have been 2 percentage points lower than what was observed. However, real gross domestic product (GDP) would have been 0.2 percentage points lower. The model suggests that the Fed got the timing right. 

Inflation in the US stayed above 5 per cent until March 2023. Even last September, it was above the target rate of 2 per cent. The conventional wisdom is that when inflation stays high for so long, it is very difficult to get the inflation rate to fall without a substantial sacrifice of growth. Yet the sacrifice of growth has been minimal. There are several explanations for this seeming miracle.  

First, as the IMF points out, inflation expectations stayed “anchored”, that is, people did not change their long-term expectations. One can only speculate as to why this happened. It may well be that the credibility of central banks has gone up in recent years.  Economic agents may have seen the pandemic and the deviations from the inflation target that happened as a black swan event. They may have believed that central banks had the competence to bring inflation to heel sooner rather than later. 

Secondly, the Phillips curve appears to have steepened during the high inflation period. This implies that any monetary tightening and the economic slack it creates would result in a greater reduction in inflation than when the Phillips curve is flatter. Central banks end up producing better results than in normal times.  But then how on earth are central banks to anticipate the steepening of the Phillips curve in such times? 

Thirdly, high inflation rates did not trigger a wage-price spiral that would have rendered the inflation rate stubborn. One reason certainly is that the power of trade unions in the advanced economies has declined and workers have less bargaining power.  

Fourthly, the increase in commodity prices was less than, say, during the oil shock of the 1970s, and the energy-intensity of economies itself has declined. Inflation caused by commodity shocks is intrinsically less of a problem today, and a lighter hand is needed to deal with it. It is fair to say central banks have been helped by a combination of favourable factors. 

One issue remains. Should central banks have started cutting rates even earlier? Well, with the geopolitical risks that we face, central banks have to tread warily. The conflicts in Ukraine and West Asia have escalated. Either could have spun out of control — and still can. The American presidential elections have posed their own uncertainties. No central bank wants to loosen policy only to tighten soon thereafter. 

Getting policy right in the face of so many imponderables will always be a challenge. In the present round, central banks have had the last laugh. Whether their success is due to tactical genius or pure serendipity is anybody’s guess.  

ttrammohan28@gmail.com