In March 2021, the inflation rate in the United States was comfortably inside a range of 1 and 2 percent per year, considered to be price stability. One month later, the U.S. inflation rate exceeded 4 percent, and then increased to more than 8 percent. Inflation took off in most other economies too.
What do central banks do to lower the inflation rate?
Inflation takes off when a central bank permits the quantity of money to grow at a faster pace than the growth rate of real GDP—the growth rate of the quantity of goods and services available. To lower the inflation rate, a central bank must slow the growth rate of the quantity of money and aggregate demand, which it can do by raising interest rates. If the central bank raises interest rates by enough to raise the real interest rate, it will slow spending growth and eventually lower the inflation rate. The process of falling inflation is long-drawn out and its timing is unpredictable.
Which central banks are leaders in the war on inflation and which are followers?
I answer this question by looking at the policy interest rate settings of six central banks: the U.S. Federal Reserve (Fed), the Bank of Canada (BoC), the Bank of England (BoE), the European Central Bank (ECB), the Reserve Bank of Australia (RBA), and the Reserve Bank of New Zealand (RBNZ).
The leaders are the central banks that were earliest to raise their interest rates, had the highest average interest rates in 2022, and raised their rates to the highest level at the end of 2022.
Table 1 provides some data.
The first two rows are the dates on which each central bank started to raise its policy interest rate and the number of months each lagged the leader. The RBNZ is the clear leader on timing, having started to raise its interest rate in October 2021, more than two months ahead of the BoE, five months before the Fed and the BoC, seven months before the RBA, and almost one year before the ECB.
The next two rows tell us the average interest rate in 2022 and the maximum rate reached at the end of 2022. The RBNZ is again the leader, with an average rate at 1.17 percent and a year-end rate of 4.75 percent. The Fed comes second at 0.90 percent on average and 4.58 percent at the end of 2022. The BoC a close third, the BoE fourth, RBA fifth, and again, the ECB last.
The remaining rows of the table display the ranks of the central banks, calculates the average rank, and assigns an overall rank, which from leader to last follower is RBNZ, BoC, Fed, BoE, RBA, and ECB.
Figure 1 provides a visual of the leaders and followers.
Are the leaders delivering lower inflation outcomes?
Table 2 provides some inflation data.
New Zealand has the lowest peak inflation rate, but Canada and the United States end 2022 with the lowest inflation rate. The Euro Area (the countries of the European Union that use the euro) and the United Kingdom have the highest peaks and the highest end-2022 levels. The overall inflation rank from leader to last follower is BoC, RBNZ, Fed, RBA, BoE, and ECB.
Figure 2 provides a visual of the inflation performances of the six economies.
A correlation, but not a perfect one, exits between the overall rankings of policy and inflation outcomes. The United States ranks third on both, and the Euro Area ranks sixth on both. New Zealand and Canada are ranked higher than the United States, but New Zealand, with the highest policy rank comes second to Canada on the inflation rank. And the United Kingdom and Australia are ranked lower than the United States, but the United Kingdom, with the fourth policy rank, has higher inflation than fifth-ranked Australia.
Are central banks winning and close to victory in the war on inflation?
It is not possible to know whether central banks are winning the war and close to returning to low inflation. But there is reason to worry that even the leaders are not doing enough, and the followers have much more to do.
The reason to worry arises from the distinction between a nominal interest rate and a real interest rate, along with a lesson that central banks learned the last time they conquered inflation.
An economy’s nominal interest rate is the rate set by its central bank, and an economy’s real interest rate is its nominal interest rate minus its inflation rate. But the real interest rate, not the nominal interest rate, influences aggregate demand.
The lesson is that to lower inflation, the real interest rate must rise. Equivalently, the central bank must raise the nominal interest rate by more than the increase in the inflation rate.
If the central bank raises the nominal interest rate by less than the increase in the inflation rate, the real interest rate falls, which lowers the cost of borrowing, increases aggregate demand, and eventually raises the inflation rate; and if the central bank raises the nominal interest rate by more than the increase in the inflation rate, the real interest rate rises, which raises the cost of borrowing, decreases aggregate demand, and eventually lowers the inflation rate.
This forgotten lesson was learned the last time the Fed conquered U.S. inflation. The year was 1981. Inflation had risen above 2 percent per year in 1966 and fluctuated peaking at 10 percent in 1975 and at 9 percent in 1981. The Fed raised its policy interest rate to 18 percent and kept it higher than the inflation rate. Inflation eventually returned to 2 percent but not for a further 15 years.
Table 3 below shows the changes in the real interest rate in our six economies.
The real interest rate has risen in Canada and the United States by a very small amount, so in those two economies, monetary policy is operating to slow inflation. But in the other four economies, and especially in the Euro Area, the United Kingdom, and Australia, the real interest rate has fallen, and monetary policy is increasing its stimulus to aggregate demand.
Even in the United States and Canada, the level of the real interest rate is negative, so although monetary policy has lowered its stimulus to aggregate demand, it continues to stimulate.
Table 4 below shows the levels of the real interest rate in our six economies.
The interest rate levels needed to take the real interest rate in each economy to zero, are the inflation rates, and these levels are the bare minimum needed.
The negative real interest rates carry the risk that monetary policies are not doing enough to restore price stability. If the risk becomes reality, inflation will persist and possibly increase further until central banks rediscover the lesson they learned almost half a century ago.
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