Wealth Managers Column: The Central Banks Dilemma | news
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The structures of the economy have changed rapidly since mid-2020. In fact, today’s situation resembles the economic development after the Yom Kippur War in 1973 and the subsequent oil price shock. The incorrect assessments at the time ensured that the price surge from the energy markets really got the general inflation dynamic going. How does she have to monetary policy so be designed now? A scientifically recognized indicator for the appropriate key interest rate is the so-called Taylor interest rate, named after the US economist John Taylor. In the early 1990s, he succeeded in making the central bankers’ monetary policy more transparent with a simple theory. He proved that inflation can only be combated effectively if the interest rate moves above the rate of inflation. Put simply: if inflation rose by one percentage point, this would have to be answered with a rise in interest rates of 1.5 points. The formula he developed takes the inflation rate, exchange rate and gross national product of the respective national economy into account. In return, the key interest rate should fall if actual economic growth threatens to fall below potential growth. That’s the theory.
Central bank policy since 2008 in other ways
Unfortunately, however, since the fight against the financial crisis in 2008, the central banks have found themselves in completely different waters. Their easy-money policies fueled a wide variety of asset price bubbles. Hardly anyone was more concerned about this mismanagement – inflation rates remained low. The main reason for this was the competitive pressure in the globalized economy. The central banks were able to continue their loose monetary policy, although it was clear that we had been in the red for some time. The interest rate hikes that have now taken place will only take full effect after two to three quarters. Oversteer would push the economy into an even deeper recession than we now expect.
Expected inflation becomes crucial
The most important for the time being are the inflation expectations of companies and households. If they expect rising prices, workers raise their wage demands, which in turn pushes up prices. A wage-price spiral is imminent. All the more important is the psychological signal from the ECB that it will continue to raise interest rates, i.e. that it will fight inflation consistently, even if there is a recession. If the ECB succeeds in preventing high inflation expectations from becoming permanent, there will be a noticeable fall in inflation in 2023.
Conclusion: The central banks have meanwhile arrived at a paradigm shift. The theories that have been worked on so far have been caught up by market developments. For the ECB in particular, it must make it clear to the markets, using much tougher words, that currency stability is its most important goal. A moderate further rise in interest rates is the only room for maneuver to get inflation expectations for 2023 under control. Hesitant action will only exacerbate the dilemma.
by Wolfgang Köbler, KSW Vermögensverwaltung AG, Nuremberg