14/10/22, 15:39 The post-pandemic recovery has been officially cancelled | Financial Times

Opinion  Free Lunch

The post-pandemic recovery has been officially cancelled
Taking on some lazy arguments for monetary tightening

MARTIN SANDBU

One message that has been coming through very clearly from the IMF this week is that central banks must act aggressively
against inflation while the economic outlook is very uncertain © Stefani Reynolds/AFP/Getty Images

Martin Sandbu YESTERDAY

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I wrote last week that the IMF has often been at the forefront of the economic
paradigm shifts of the past 10 to 15 years. But this week’s IMF/World Bank annual
meetings show that the fund can also be right in the middle of the unreconstructed
mainstream. One message that has been coming through very clearly from the IMF
this week is that while the economic outlook is very uncertain, central banks must
act aggressively against inflation. The fact that the aggressive monetary tightening
under way is about to end one of the strongest labour markets in living memory, as
I wrote in my column this week, does not carry much weight in Washington. And
the fund goes beyond just calling for central banks to “stay the course” — it also
wants fiscal policy to support them in restricting aggregate demand.

Reasonable people can disagree on the right macroeconomic stance, but I want to
address some lazy arguments for tightening that I have heard over the past week.
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Here are four:

First, it is claimed that monetary policy is still at stimulative levels rather than
neutral, let alone restrictive. This claim is lazy because it simply presupposes that
because absolute levels of central bank interest rates remain low by historical
standards, that means monetary policy is loose.

This ignores that the rates targeted by central banks affect the economy by
influencing the overall financial conditions facing businesses and households.
Ultimately it is these conditions that have to be appropriate for meeting the central
banks’ policy goals, which is why good central banks should adjust their own
instruments to what financial markets are doing on their own. For example, if a
moderate tightening is seen as necessary, and financial market conditions get
tougher for other reasons, there is no need to raise central bank interest rates
(unless the market tightening happened merely in expectation of such a move).

More generally, a low central bank interest rate should not be seen as stimulative,
if it permits overall financial conditions that are contractionary. And that is the
case today. The IMF’s Global Financial Stability Report, out this week, documents
that financial conditions in all the advanced economies are a little tighter than
their 25-year average, and quite a lot tighter than they have been at any point in
the past decade except at the start of the pandemic.

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Another lazy argument is that because inflation has gone up, real central bank
policy rates have gone down. So central banks must run just to stand still, and
raising rates may not even amount to tightening. But again, central banks have an
impact through their influence on the behaviour of people throughout the
economy. Nobody chooses an investment on the basis of the “instantaneous” real
interest rate (the shortest-term central bank rate minus this month’s inflation).
They assess the real rate over the lifetime of their assessment. And on any time
horizon that matters in the real economy, real rates have gone up by a lot.

The fund’s own GFSR finds that real rates have gone up by about 1 percentage
point since April for five- and 10-year government borrowing in the US, and nearer
to 1.5 points for the eurozone. That also implies that the “five-year, five-year” real
rate — the cost of borrowing over five years starting five years from now — has
risen by about the same. Someone planning to buy, say, energy efficiency
equipment — a heat pump? an electric vehicle? — in the coming years now faces
significantly higher financing costs after inflation. And as it happens, the fund
reports that even one-year real interest rates have risen significantly (see the chart
below).

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The third lazy argument is that central banks cannot target long-term interest
rates, a policy known as “yield curve control” (YCC). It would destroy their
credibility as inflation fighters by making them look like they are taking orders
from profligate finance ministers to lower public borrowing costs. Therefore, YCC
would complicate the monetary tightening most central banks now think (wrongly,
in my view) they need to undertake.

Set aside the obvious problem that the one central bank that practises YCC is the
one with the least inflationary pressure (the Bank of Japan). The bigger issue is
that this objection to YCC is based on two confusions. The simpler one is the
intellectual error of conflating the idea of targeting long-term rates with the risk of
targeting it at the wrong (too low) level. But there is nothing that stops a yield
curve-controlling bank in the mood to tighten from jacking up the long rates to
whatever level tightens financial conditions enough.

That, however, points to the second and much more substantive confusion. The
Bank of England’s emergency interventions in the past two weeks show that while
it is very keen to say it does not want to steer the UK government’s long-term
borrowing cost, in practice it has very strong opinions about gilt yields. It clearly
found that gilt yields rose too fast and too high after the government’s “mini”
Budget (otherwise why intervene?). So there is a contradiction between what it
wants and what it says it wants. But there is also a contradiction between the
different things it wants — contained gilt yields for financial stability reasons,
higher ones for monetary policy reasons. But because it does not formally target
longer-term gilt yields, it has not been forced to make up its mind. No wonder
markets are seesawing.

The Old Lady of Threadneedle Street is just the most extreme example. Other
central banks risk the same confusion. The original sin here may have been to opt
for quantitative easing (QE) — buying government bonds — instead of yield curve
control in the global financial crisis: central banks chose a policy whose objective
was clearly to bring yields down but refused to say where they think the yields
should be brought down to. It is telling that the BoJ, which started QE long before
anybody else, is the one central bank that has opted for YCC and stuck with it.
Others will find that this confusion from treating long-term yields as values that
M tN tB N d ill l t
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Must Not Be Named will only get worse as QE turns to quantitative tightening — as
the BoE’s forced postponement of bond sales this month shows. I argued last year
that the European Central Bank should adopt yield curve control; the argument
holds for other central banks too.

What, finally, to make of the IMF’s insistence that fiscal policy should not work at
“cross-purposes” with monetary policy? This view — not at all unique to the fund —
breaks with tradition in two important ways. One is intellectual. Part of how
central bank independence was supposed to work was a division of labour with
finance ministries. Elected politicians would take the political decisions of fiscal
policy, about who pays and who gets what — which surely includes how to
distribute spending and taxes between current and future generations of taxpayers,
also known as the deficit. Monetary technocrats would then use interest rates to
stabilise the economic cycle. Now, it seems, fiscal decisions should be subordinated
to monetary ones.

The more recent tradition is hardly two years old: it is not so long ago that
governments around the world were launching recovery plans to rebuild their
economies from the pandemic (even “building them back better”). But now it
seems the priority is to restrain growth. Telling fiscal policy to support monetary
policy in containing aggregate demand only makes sense if the economy is above
its sustainable potential, in other words, that there is no more growth damage from
the pandemic left for macroeconomic policy to heal. So goodbye post-pandemic
recovery, it was nice knowing you, however briefly.

Other readables
• The Nobel Prize in economics was awarded for work that remains
depressingly relevant: why there are runs on banks and how badly
they damage the economy.

• Gábor Mészáros and Kim Lane Scheppele convincingly demolish any

illusions about Hungary’s rush to set up an “integrity authority” to
avoid being cut off from EU funds on the grounds of defective rule of
law.

• My explanation two weeks ago of the turmoil following Britain’s

“mini” Budget was the realisation that the government genuinely
b li i Th t h it th
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believes in a neo-Thatcherite theory of what creates economic growth
which market participants have long since rejected as false. My
colleague Helen Thomas has an excellent column on how the same
alienation is taking place in the business community.

• The FT’s special report on Women in Business is out.

Numbers news
• There is a 10 per cent risk of the global economy contracting,
according to the IMF’s Global Financial Stability Report.

• Behind the numbers, FT readers share how the cost of living crisis
affects them.

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