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The writer is president of the Peterson Institute for International Economics
With the European Central Bank and Bank of Canada having cut interest rates this week, attention has now turned to the US Federal Reserve and its keeping rates “higher for longer” stance. But we shouldn’t lose sight of the bigger picture in monetary policy. The more we look at how similar interest rate policies have applied to very different economies, the more we should wonder at the similarity of the outcomes.
Since the shock of Covid-19, followed by Russia’s invasion of Ukraine, the Eurozone, the US and, for that matter, Canada, the UK, Brazil, Mexico and most other sizeable monetary areas (with the exception of Japan) have followed roughly the same path of inflation and interest rates. Team Transitory may argue that these were global shocks and that therefore this similarity was only to be expected. But that is flat out misleading. Yes, the shocks were global, but the common path most have followed means that several other important economic factors appear not to have mattered. That is striking and important.
Consider the following differences between the Eurozone and America. The US exports food and energy, Europe imports them; the US exports weapons and munitions, Europe imports them; the US is an ocean away from the war zone in Ukraine, the EU is absorbing millions of refugees and faces overt risk. Or take the pandemic. During it unemployment in the US spiked to over 20 per cent while in the EU it barely rose, due to fundamental differences in labour markets and support policies. After adopting similar stances initially during Covid-19, the US maintained large fiscal expansion for far longer than Europe did. Finally, the euro is not used anywhere near as widely in trade, finance or reserve portfolios as the dollar.
In the US, households’ propensity to consume and borrow is much higher than in the Eurozone. This has shown up in the rapid drawdown of excess savings accumulated during the pandemic. Meanwhile commercial and real estate lending in the US has migrated from traditional banks to largely unregulated private lenders to a much greater extent than in Europe.
You might expect that variations in corporate concentration and antitrust policy between the two regions would yield divergence in their price setting behaviour. And although organising has strengthened recently in the US, unions and collective bargaining still play a far greater role in European wage setting. But despite all of this potential to divert nations from a common path, similarly sized and paced interest rate moves by central banks on both sides of the Atlantic had apparently the same effect on inflation with roughly the same lags in both.
So, do differences in labour market institutions, fiscal paths or even labour productivity, really make no difference to monetary transmission and the persistence of inflation? That is what a lot of modern monetary theory tells us. In our 1998 book Inflation Targeting, Ben Bernanke, Thomas Laubach, Frederic Mishkin and I said, in effect, that if an economy set up an independent central bank with a transparent low inflation target, that would anchor longer-term inflation expectations. This would in turn mean that monetary policy could respond flexibly to shocks in the short run, while inflation would still return to target if policy remained consistent.
Over the past four years, that has turned out to be the case. And this is so despite differences in national economic structures and the ways in which monetary policy works its way through each system. A recent series of central bank research papers, which have applied the model developed by Bernanke and Olivier Blanchard for the US to their own economies, have yielded similar results. While labour market differences did show up as statistically significant, they were second order. Over-interpreting such small differences in the persistence of inflation would only result in a counterproductive fine-tuning of policy.
So, what have the past few years taught us? We have learnt that people in high-income democracies still really dislike inflation, so this monetary regime appears to have considerable political legitimacy. There is a parallel here with the “end of history” argument made about liberal democracy after the fall of the Berlin Wall in 1989: there really are no credible alternative monetary regimes.
Independent central banks and low and transparent inflation targets are a killer combination. That is why all large economies, with the exception of China, and the vast majority of high- and middle-income economies have adopted it. Where autocratic leaders in India and Turkey have leaned on their central banks and pushed down interest rates despite rising inflation, they have paid an evident price.
This does not mean that there won’t still be inflation shocks and struggles for scarce resources, just as the putative end of history in the political sphere did not snuff out war and ethnic strife. Monetary history continues — sort of. But we should pay more attention to the similarities in central bank policy in recent times than the current discussion seems to.