Negative real rates will not dampen inflation

  • Inflation continues to surprise central bankers on the upside
  • Yet planned/expected interest rate moves will still leave real policy rates negative for years
  • With broad money growth again accelerating, this means continued above-target inflation 

Another month has passed, another month when inflation surprised on the upside in the major Western economies: US consumer prices rose by 6.2% in the year to October, as against 5.8% expected, EA inflation was 5.2% in November, 5% expected and so on). Producer price inflation is also accelerating, reaching 8.6% in the USA, 8% in the UK and 16% in the EA.

On the positive side, central banks finally seem to be waking up to the fact that inflation may prove longer lasting than expected. Perhaps more importantly, politicians also seem more aware of the dangers of inflation. I have previously written that governments want higher inflation – not too high, not for long, but just enough to make a sizeable dent in the new debt they have taken on over the past two years and are lining up for the next few years as well. At least in the case of Mr Biden, I seem to have been wrong. The White House has apparently told the Fed to stop worrying about the 8 million unemployed and think about the harm inflation is doing to the 200 million employed. Admittedly, in Europe the ECB is still convinced that inflation will fall as early as at the beginning of 2022 (see, e.g., Mme Lagarde’s interview with Frankfurter Allgemeine Sonntagszeitung on 28th November). And we shall of course see if the Bank of England does raise interest rates at its December meeting, following its peculiar failure to do so after clearly flagging a hike in the November.

Awareness of inflation is welcome. However, it is still not clear that this is translating into effective action. Yes, there is now talk of (possibly) higher interest rates. But whether we look at market expectations or central banks’ own projections, policy interest rates are forecast to rise by perhaps 50 or at most 100 basis points over the next two years, depending on the country. That would still leave real interest rates massively negative. The FOMC’s latest dot plot shows the median forecast of the Fed Funds rate at 1% by end- 2023. Even if inflation were to fall back to target by then, this still means a real interest rate of -1%. The Riksbank expects its repo rate to reach 0.1% by 2024 – again, implying a real interest rate of -2% assuming inflation falls back to target. And so on.

But why would inflation fall back?  We are told that so many of the factors (changing somewhat from month to month) are once-offs – the prices of second-hand cars, say, or supply chains. This may indeed explain the inflation number in any given month. But, as John Cochrane points out, the fundamental reason why prices are rising is because demand is outstripping supply. In turn, this strong demand comes from the fact that households (and companies) are flush with cash after the various policy measures (furlough pay, tax rebate cheques etc) implemented during the pandemic, and are now spending.

Crucially, unless broad money growth begins to fall back towards a 4-6% range, there is little likelihood that inflation will actually ease on a sustainable basis. And that – the monetary slowdown – does not seem to be happening. US broad money growth has accelerated after a lull during the summer and is now again in the (low) double digits. British and Euro Area broad money growth (M4x and M3 respectively) has slowed slightly in recent months but remain high (7.7% in the year to October in both economies). More to the point, on a three- and six-month annualised basis, a better guide to recent trends, broad money growth in both these economies is again accelerating. This is partly because the growth of credit to the non-bank private sector is picking up after a long period of pandemic-induced weakness.

Yet economic history shows that what matters in slowing broad money growth and bringing down inflation is real interest rates, not nominal. Taking nominal interest rates from 0% to 1% or even 1.5% will do little to dampen inflation running at 3, 4 or 5% or higher. 

Central banks have rightly felt that they cannot risk aborting the recovery. But global GDP has already overtaken its pre-pandemic levels and continues to expand. If interest rates cannot now be raised to combat higher inflation, when can they ever be? More to the point, central banks have spent many years trying – and failing – to reach their inflation targets from below. It would be unfortunate (to put it mildly) if we were now to return to a situation where they spend years trying in vain to reach those same targets from above because they fear that their economies cannot withstand non-negative real interest rates. Yet that may be exactly where we are heading.