Economics Update August 2023 - Between inflation and weak economy: acid test for monetary policy

The meetings of the decision-making bodies of the Fed and the ECB in July have shown: Both central banks are determined to bring inflation back to the 2% target. Monetary policy will therefore remain restrictive for the time being. There will therefore be no interest rate cuts until the end of the current year. The real question that now arises is: When will the point be reached at which further interest rate hikes are no longer necessary to achieve the inflation target, but instead further slow down economic momentum and possibly also endanger the stability of the banking system?

Central banks with a risky balancing act

If central banks continue to tighten monetary policy beyond this point, the risk of a recession increases. Conversely, cutting interest rates too early would be even riskier. If the Fed really wanted to manage a "soft landing" of the US economy, it would have to start cutting interest rates well before a possible recession in the US economy because of the lags in the effects of monetary policy. In doing so, it would have to be confident that, first, its assessment of the overall economic development - probable recession in about 6 to 12 months - is correct and, second, that the effect of monetary policy achieved so far is sufficient to bring inflation back to 2% despite interest rate cuts. If it fails to do so, it runs the risk that inflation will rise again and the central bank will have to resume the cycle of monetary tightening, which would not only have considerable real economic consequences but would also further damage its reputation. History shows no example of the Fed actually succeeding in this balancing act. Moreover, the recent difficulties in assessing inflationary developments as serious (and not merely temporary) at an early stage and reacting accordingly leave little room for optimism that this time could be different. In view of these uncertainties, a monetary policy that makes its decisions in accordance with the situation, depending on the available inflation data and taking into account the cyclical dynamics, seems appropriate in any case.

US recession more likely than a soft landing

The Fed is therefore well advised to continue to pursue the inflation target as a priority and to accept possible recessionary developments if necessary. It will probably maintain its maximum key interest rate for a longer period of time, well into 2024, in order to minimise the risk of a second wave of inflation. This means, however, that a macroeconomic recession of the US economy has a much higher probability of occurrence than a "soft landing". The question is therefore not whether, but when such a recession will occur. From today's perspective, the first half of 2024 seems the most likely time.

The ECB faces two additional challenges: First, it has to keep an eye on the heterogeneity within the euro area - the spread between the lowest and the highest core inflation rate in the euro area is currently about 6.5 percentage points. Second, the euro area economy has been weakening for a long time, so the question is how much additional loss of momentum as a result of further monetary tightening seems opportune. Discussions within the ECB Governing Council are likely to become audibly more controversial in the autumn.