Inflation now, (no) growth later
When you tame inflation by using monetary policy you are influencing the demand function within an economy. By tightening monetary policy, you can by definition only constrict the available capital within an economy and therefore attempt to reduce demand and spending. There is no expected constructive supply side adjustment to control inflation. Regarding the supply side, tighter policy may have the impact of driving more participants back into the labour force as costs of debt servicing rise. However, it is just as likely that the constraints on the availability of capital within the economy will constrain supply side development and spending, perhaps even halting those in progress before the hiking cycle.
What is far more predictable and intended is that a constrained demand function in turn allows equilibrium prices to fall (read as the inflation rate), provided that aggregate supply remains constant. This is the logic that central banks normally dish out during a period of high inflation and monetary tightening to explain and justify their logic and actions. The uglier side of the picture regards growth. Growth and inflation are often highly positively correlated and can at times have a causal relationship upon each other.
By definition, artificially suppressing aggregate demand within an economy in order to tame inflation will create knock on effects to economic growth. This is an axiom, and it is not something that central bankers like focussing on. But at the same time, it is not something that they will deny either if challenged. Policy makers would merely frame the risk to growth as a cost of getting the job done. Over the past week or so the terminal rate in most global economies has not only been pushed higher but also been revised back later according to pricing in the bond market. As a result of this repricing, the risk to growth is currently taking a more central place in central bankers’ rhetoric surrounding monetary policy. From Jay Powell’s testimony this week, it has not been hard to identify the Federal Reserve’s concern surrounding, but also willingness to sacrifice, future growth.
Rather than rate cuts later this year, interest rate expectations have been dragged higher with almost every major economy now having their first rate cut priced in 2024, not 2023. Higher rates for longer will have a necessary impact upon economic growth creating two important trends for long run economic outlooks. Firstly, the subsequent path of rate cuts may be steeper but further off. This could create more instability with the bond market for years ahead raising general levels of volatility. Secondly, a contractionary global environment creates hugely divergent winners and losers within the FX market with a focus upon fiscal and monetary credibility taking precedence over factors such as interest rate differentials.
Discussion and Analysis by Charles Porter
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