Central banks need to remain steadfast, vigilant on inflation


The central banks of the US and Europe made significant changes to their monetary policies during the pandemic that differed greatly from what they had done before. When inflation rose slightly beyond the target, those in charge of setting interest rates vowed to remain calm after a decade of below-target inflation.

Following a string of supply-side surprises that upset central bankers, this should have calmed them down. They maintained their composure throughout the following price increase for a time. However, they lacked the courage to persist with their new ideas.

Instead, they let objections stop them from thinking that strong demand pressure could bring more resources into the economy than what was thought before. This would help keep price pressures down while keeping growth robust.

The phrase "If it doesn't hurt, it doesn't work," is now being revived by central banks, but in a financial sense. Leading politicians are becoming more explicit about their strategies for reducing inflation, even if it involves slowing growth or laying off people.

In the wake of rising inflation

Initially, the rise in inflation was generally attributed to supply disruptions. Even if it is obvious that Vladimir Putin's invasion of Ukraine and the subsequent limitation of gas supply contributed to the issue, the mainstream opinion has been shifting towards excessive demand.

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However, this is the first year since the pandemic when nominal expenditure in the US has increased. In either Europe or the UK, this hasn't happened yet. Even in the US, the total volume of products and services purchased (instead of their market worth) continues the pre-pandemic pattern.

Demand could be almost normal, but supply might not be due to the pandemic or the sharp rise in energy and commodity costs. The pandemic may have reduced the number of healthy employees, which might have harmed the economy's capacity to generate income.

But not in Europe, where several countries have the highest rates of employment. Even though there are roughly a million fewer people employed in the US than there were in February 2020, the current boom is still adding employment at a rate that is more than twice as fast as it was prior to the epidemic. Additionally, job growth is still very high in continental Europe.

There are few indicators of this bubbliness. However, if central banks were determined to halt the demand expansion, they could do it. The situation with energy crises is likewise.

In order to satisfy their energy demands, countries that import more energy than they export will need to export more and use less energy due to the high prices of oil, gas, and electricity.

Avoid price-wage spiral

Cuts in production will not help to solve this problem when jobs and investments are affected by the contraction policy. The tightening of money can exacerbate inequalities caused by rising energy prices in countries that export more energy than they import.

The last reason to tighten in a recession caused by supply is to stop a wage-price spiral. But this makes sense only if the risk is more than just a thought experiment.

Wage increases are good, and the fact that prices aren't going up because of them suggests that wage costs are not the cause. It's also important to note that France, Italy, and the Nordic countries, which have the most collective bargaining, also have the lowest inflation rates.

None of this should take away from the real pain that the cost of living crisis has caused. But cutting back on money before a recession will only worsen the issues.