Why cautious monetary policy is a risky business

By sustaining high interest rates, purportedly to slay inflation, central banks are risking an unnecessary recession.

In its latest interim Economic Outlook, the Organisation for Economic Co-operation and Development calls for monetary policy to be ‘prudent’, to remove the residue of inflation from the system by slowing down the economy. The OECD acknowledges that central banks may pursue initial rate cuts in the second (United States) and third (euro area) quarters, but beyond that recommends that monetary policy remain restrictive. In its view, core inflation is still above target and service-sector inflation and wage growth are still strong—this implying, together with geopolitical tensions, that it is too soon to be sure inflation has been defeated.

Yet by recommending that high interest rates be sustained, the OECD is risking an unnecessary recession. Two facts cast doubt on the wisdom of a restrictive monetary stance.

‘Downward risks’

The first is well described by the OECD’s own report. Identifying ‘downward risks’, it says:

[T]he tightening of monetary policy over the past two years has been of a scale and speed rarely seen in the past … The feedthrough of higher lending rates into household and corporate debt service burdens remains partial … As this debt matures, or loan conditions are adjusted, the impact of higher interest rates will be felt increasingly.

To illustrate this mechanism for eurozone households—it is basically the same for other regions and economic agents—the average mortgage rate paid by households only increased by 0.8 percentage points in 2022-23, while the rate on new mortgage loans went up by 2.7pp. So, even if the European Central Bank does nothing further on interest rates, time is automatically doing the work of monetary restriction: the full effect of the higher rates will increasingly hit households, businesses and governments over time, reducing their spending and slowing the economy further.

A second fact, not mentioned in the report, is that the measure of year-on-year inflation is very misleading. Inflation measured this way is indeed still above target—2 per cent for the ECB and the US Federal Reserve—but it reflects price shocks occurring 12 months ago. Using three- and six-month annualised inflation rates reveals that disinflation has advanced much more than these year-on-year numbers would indicate.

The three-month annualised core inflation rate reached just 1 per cent in December in the euro area while it has been around 1.52 per cent for the past half year in the US. Price pressures which boosted inflation a year ago have eased significantly over recent months. So currently prices are rising very modestly, below the inflation target.

For those of us who argued all along that inflation was driven by temporary supply-side disruptions, not by systematic overheating on the demand side, strong disinflation does not come as a surprise. While the exact timing was difficult to predict, inflation was always expected to weaken on its own once supply bottlenecks had been overcome.

Policy too tight

Putting these two things together highlights the risk that monetary policy is too tight. If inflationary forces have largely disappeared, the unfolding slowdown—driven by past monetary restriction finally hitting the economy—is unnecessary.

Most economic policy-makers however disregard the possibility that monetary policy is on course to inflict unnecessary damage on the economy and the labour market. A notable exception is the International Monetary Fund, which speaks of ‘adjusting rates to avoid protracted economic weakness and target undershoots’. And some at the Bank of England argue that keeping rates high, instead of cutting them substantially over two years, will do little to change the inflation outlook but make a big difference to economic activity.

An unnecessary slowdown implies the risk of moving the economy beyond a ‘point of no return’—breaking something in its backbone which will be difficult to repair. What if the increased interest payments households, businesses and governments would face if rates were kept high were to mean employers no longer hoarding labour but turning to mass redundancies? What if the resulting jump in unemployment were to trigger an explosion in loan defaults, creating another financial crisis? And what would happen to financial stability if segments of financial markets faced waves of expensive debt refinance, should interest rates remain high over the coming year and more?

Policy-makers also need to transcend a trade-off between growth and price stability. In the scenarios mentioned above, keeping rates ‘high for longer’ would not only damage the real economy but push inflation down from close to target to far below target.

Dwindling rapidly

In this way, central banks risk bringing us back to the last decade—the economy flirting with deflation, interest rates stuck at zero and monetary policy powerless to stage a convincing recovery. There is a paradox here. Erring on the side of caution by sacrificing growth and jobs to avoid any risk of inflation returning would not realise central banks’ goals but result in the opposite: price instability with inflation falling significantly below target.

Having failed to cut interest rates in time to prevent an unnecessary weakening of the economy, central banks will be seen as being ‘behind the curve’, their actions then as ‘too little, too late’. This in turn will reflect poorly on their credibility, damaging their capacity to manage the economy.

After misdiagnosing high inflation by underplaying the role of supply-side shocks, economic policy-makers face a conundrum of their own making: inflationary pressures are dwindling rapidly while past monetary restriction continues to drive depression and disinflation. Central banks and the institutions advising them should recognise this challenge. Instead of trying to discover new inflation risks in essentially backward-looking data, they should rebalance their approach and focus on getting monetary policy back ‘in front’ of the curve. There is no time to waste to reverse an overly restrictive monetary stance and deliver deep interest-rate cuts.