Former World Bank Chief Economist: "Inflation is still sticky. The test of the Fed's determination is still ahead of us"
Former World Bank Chief Economist: "Inflation is still sticky. The test of the Fed's determination is still ahead of us"
Prof. Carmen Reinhart, the former Chief Economist of the World Bank commends the US Fed for its aggressive handling of inflation and the banking crisis: "Interest rates are expected to be high for a very long time, even when the signs of a slowdown begin to increase"
"I am very satisfied with the way the Fed dealt with the banking crisis. After all, in the first days of the SVB crisis, they could have said, and there was even an expectation that they would say: 'Well, we will have to adopt a more flexible' or more 'adjusted' policy and make the policy more comfortable. I hoped they wouldn't do that, and they didn't," says the former Chief Economist of the World Bank, Prof. Carmen Reinhart.
According to Reinhart, the financial authorities reacted very aggressively and expanded liquidity while at the same time adopting an aggressive monetary policy of raising interest rates. "They did what a central bank should do, but did not back down from raising interest rates. After all, there was a fear that we were returning to the panic of 1907. But I emphasize that they have done all this until now. We will see if they have the determination to continue, because the inflation we see is sticky and persistent. The test of the Fed's determination is still ahead of us."
Do you think the banking crisis is behind us?
"I don't think it's behind us, but I also don't think it's systemic, at least not now. This crisis reminds me of the savings and loan crisis of the 1980s in the U.S. It was also not systemic, but it was persistent, it cost a lot of money to fix it, and what created it was the sudden jump in inflation (which caused the interest rate to jump). Even then there was a lot of complacency, because the central banks were not prepared for interest rate increases and thought even then that it will be lower for longer or more precisely low forever. The mortgages with fixed interest rates for 30 years were ridiculously low. There was no preparation in those financial institutions for savings and loans for the large increase in the real interest rate."
The fear is that when the signs of a slowdown or recession begin - then the banks will get cold feet.
"Although the labor market is functioning well, there are already signs of weakness there, for sure, even though the indicators in this market are lagging. The housing market has already taken a turn, as has interest-sensitive consumer spending. We remember what happened in the 1970s: the inability to lower inflation was partly due to the too early declaration of victory over inflation, and the too early reversal of policy. Usually the reversal of policy (reduction of interest rates) comes because the economy enters a recession. We're not there yet, but don't worry - the Fed will have to consider this as well."
Praising the Fed is pretty rare these days. There are economic experts who attack the Fed harshly and claim that it cannot be trusted. The Fed is in the midst of a massive crisis of confidence.
"I know the criticisms. The fact that the Fed started too late with the interest rate hikes is completely true. They preceded the ECB but arrived completely late to the party. Regarding the supervision of the banks - the Fed warned Silicon Valley. If you go to the report of the Board of Governors there is a reference to the events and they weren't entirely surprised by it. The alarm bells were ringing, but they were too timid and weren't effective. It may have been because they didn't want to create a self-fulfilling prophecy."
The criticism is also regarding the relationship with the markets. The Fed fails to convey messages successfully.
"Powell has to deal with a capital market that is hopelessly optimistic. When you look at the expectations of the market as they are reflected in what is embedded in forward interest rates, the market estimates that inflation is going to come down quickly, there will be some slowdown, the Fed will reverse policy, it will also stop the hikes and will even begin to reduce interest rates. The problem is that this scenario is not consistent with reality and the capital market."
According to Reinhart, "Investors are taking the best of both worlds: both that inflation will be tamed quickly and that the Fed can return to lowering interest rates very soon. I don't think so and I don't think the Fed thinks so. Powell explained several times, quite consistently, that the problem is that inflation is sticky and that the interest rates may have to remain high for a longer period of time. So last week they issued the statement that there may be further interest rate hikes. Well, then? They did not write that they are not raising interest rates any more and certainly not that they are starting to lower interest rates. They left the door open."
Reinhart says that the numbers speak for themselves: inflation is touching 5% and core inflation - inflation without energy and food - is even higher: 5.5%.
Do you think the big increases are behind us?
"In historical terms, when looking at the periods with real interest rates from 1870 onwards, the current cycle from 2008 to 2023 was the longest of all compared to the three previous cycles: World War I, World War II and the 1970s. The graph also shows that the exit from periods of negative interest rates in the previous three periods included recessions and even double recessions. This is also why the current assessment of a 'soft landing' is certainly not historically based. By historical standards, real interest rates in Europe are still deep in negative territory and in the U.S. they have only just reached zero. Meaning, the interest rates are expected to be high for a very long period even when the signs of the slowdown begin to increase."
So if inflation does not fall enough and signs of economic recession appear, what will the central banks do?
"It is encouraging that both Powell and Christine Lagarde, the president of the European Central Bank, have turned against the narrative of temporary inflation. These are good indications that they understand the seriousness of the problem and that there is also a problem here that requires persistence. But…”
Yes, I was waiting for the "but".
"Because in the end the proof is in the pudding," Reinhart uses an English expression which means that the real test is in the final result. "I was in Sweden a few weeks ago and inflation there dropped to 8% and the interest rate was at 3% before the recent increase of 50 basis points. The debate was whether to continue raising the interest rate because they were concerned about the high level of consumer debt and also the high weight of variable rate mortgages. But you have a negative interest rate of 7% there! Suddenly you see that Australia has also stopped, and Canada has also stopped, and as mentioned, the Fed and the ECB - they are still standing before their big test."
You aren't ruling out a scenario according to which the world, including the U.S., falls again into the trap of the 1970s, which was preceded by the cessation of monetary tightening and the result was a return jump in inflation that was much more aggressive and painful.
"On the contrary! I've been warning about it for years. We also wrote about it with Prof. Kenneth Rogoff. We claim that in the 1970s, instead of leading the markets, the Fed was passive towards them. This passivity was because they were unwilling to adhere to a strict monetary policy despite the need. After all, the problem arises when you reverse prematurely: inflation has gone down, but if you let up it does not return to where it was before. Therefore, although some success was achieved in the short term, when inflation returns, it already starts from a higher level and therefore the next jump will take it higher."
Is the inflation of the 1970s the same as the inflation of 2023?
"There are different features, but high prices are high prices - both then and now. The core of inflation for households remains energy and food - as then. Inflation also remains a type of regressive tax, there is no question about it: it erodes wages and disproportionately affects those with the weakest incomes. As you go down the deciles, the ability to hedge the risk of inflation decreases. In advanced economies, the weight of food in the consumer price index is about 16%, while among middle-income countries it rises to 20%, and in low-income countries it is already over 30% and in extreme cases 50%."
