- US broad money and credit growth continue to weaken
- But the labour market remains strong
- The Fed – and other central banks – prefer to over-react than to pause too early
Seemingly weaker inflation in most advanced economies raised market hopes that central banks are very close to the peak of their tightening cycle. This impression is reinforced by survey data, which shows price pressures easing. For a monetarist, very weak broad money data – US broad money contracted for a third consecutive month in the year to January; EA broad money growth in December was the weakest in four years – strongly supports this view. The more so as central bankers just possibly may actually be taking monetary data into account. At least, Christine Lagarde mentioned money weakness at her most recent press conference.
However, market optimism is probably premature. First, because clear signs of inflation easing really only refer to the United States. American core PCE inflation, the Fed’s preferred measure, fell to a 15-month low of 4.4% in the year to December. But this is of course still well above the 2% (or so, given the Fed’s average inflation targeting policy) target. Moreover, monthly core PCE inflation is in the 0.2-0.3% range, meaning an annual rate of anywhere between 2.5% and 3.5%. In the UK, inflation is still at or close to double digits (depending on which rate and which period you look at). Euro Area inflation is lower, with the core rate at 5.2% in both December and January but shows little sign of dropping further in the near future.
Second, the American labour market in particular, remains much stronger than would be expected at this stage in the cycle. True, labour market data are lagging indicators, so this just tells us where the economy was a few months ago. But in the US and by markets, it is perceived as a coincident or even leading indicator and certainly a leading indicator of Fed activity. Unsurprisingly, Jerome Powell, the Fed Chair, has just warned that interest rates may rise further than markets expect. (Experience shows that when the Fed Chair says something like this, it should be believed; by contrast, when the Governor of the Bank of England says that markets are too hawkish, past history implies that the comments are irrelevant.)
And there is a third point, repeatedly made here. Central banks and central bankers have for close to three decades been revered for their perceived infallibility. This has helped safeguard central bank independence (however defined) as the paradigm for monetary policy in most of the world. But when you are on top of the world, the only way to go is down. Central banks’ reputation took a bad turn during the pandemic. Their leaders are acutely aware of their repeated collective failure to predict the post-pandemic surge of inflation, as well as its height and duration. Tightening policy too much as a form of insurance carries little risk and easy to reverse. By contrast, ceasing to tighten prematurely and then having to embark on a renewed cycle of higher interest rates if inflation does not fall as expected or – due to unforeseen and perhaps unforeseeable circumstances – takes off again, is both harmful and embarrassing. Much better, therefore, to keep raising interest rates now – but to prepare to change course, perhaps in late 2023, perhaps in early 2024 – than to risk committing another mistake.