Their rhetoric is starting to lack credibility as powerful economic headwinds emerge.
Like many parents, I used to try disciplining badly-behaved children in the run-up to Christmas by telling them they would receive no presents if they persisted. This worked only fleetingly. My children quickly discovered my threat lacked credibility. The collateral costs of being present-less on Christmas morning were simply too great for anyone (me or Father Christmas) to bear — and they knew it.
This is an example of what economists call a time-consistency problem. For a future action to be credible on announcement, it must still be the smart thing to do when the time comes to act. Even if an announced action is well intended — whether to discipline misbehaving children or financial markets — it will lack credibility and prove ineffective unless following through with it would actually be sensible.
Central banks faced an acute form of this time-consistency problem in the years running up to the cost of living crisis. During that time, inflation consistently undershot its target in the US, the eurozone and elsewhere. Academics and policymakers debated the merits of a monetary strategy that aimed to persuade markets that policy would be looser for longer, allowing inflation to overshoot its target for a period. Indeed, the Federal Reserve in the US and the Bank of Japan announced monetary policy strategies intended to do just that.
Whether by design or (much more likely) by accident, a number of central banks have ended up overachieving on those ambitions recently. Over the past 18 months, inflation has overshot its target much more significantly and consistently than was ever planned.
But with global inflation now subsiding, and the economic outlook worsening, central banks face the reverse dilemma. How to discipline markets into believing policy will remain tighter for longer so as to lower inflation to target and repair central banks’ dented credibility?
Central banks have so far used forward guidance, with a bias to future tightening, to achieve this disciplining effect. And for a fleeting period over the summer, this seemed to be working, with interest rate expectations suggesting rises were more likely than not in the US, UK and eurozone during 2024 and with no rate cuts expected until 2025 at the earliest.
But, like my own attempts with my children, the disciplining effects of these so-called “open mouth” operations has been shortlived. Although central banks’ tighter for longer rhetoric remains largely unchanged, financial markets now expect significant rate cuts in the US, euro-area and UK during the first half of 2024.
Central banks’ forward guidance to markets has lacked credibility for the same reason that my own did — it does not have time-consistency given the probable economic reality at the time. Over the past three months, we have seen a clear tilt in the balance of risks to inflation and growth in the major economies during 2024, with both inflation and economic activity coming in below expectations.
The hope for economic growth in 2023 was that, with wage inflation beginning to outpace price inflation in most countries, household purchasing power would begin to recover from its hard hit, stimulating spending into the second half of 2023 and beyond. But against that are four powerful economic headwinds whose strength will only increase into 2024.
First, while real pay may now be rising, most households’ purchasing power is still materially lower than before the cost of living crisis. In the UK, households’ real incomes are not expected to recover until perhaps 2027. Second, both households and companies have supplemented their denuded incomes during their recent squeeze by drawing down savings, often accumulated involuntarily during the pandemic. That savings pool has now largely evaporated.
Third and fourth, and unlike in the recent past, neither monetary nor fiscal policies are likely to provide insurance to households and companies looking ahead — more likely the opposite. For monetary policy, the larger part of the 4-5 percentage point interest rate rise is still to hit the balance sheets of households and companies. For fiscal policy, after the dramatic expansion of the past few years, a slowing is likely to commence next year and strengthen thereafter.
All of this puts the balance of risks to growth squarely on the downside. By early 2024, inflation is likely to have ceased to be public enemy number one. It will be replaced by rising unemployment, falling confidence and spending and financial distress among rising numbers of companies and households. As the economy softens, so too will central banks’ rhetoric. They will follow an Augustinian edict — be chaste, just not yet.
Back in 2014, a UK politician labelled Mark Carney — then Bank of England governor — an “unreliable boyfriend” for saying one thing and doing another. The world’s central banks now risk a similar fate. For all their Grinch-like protestations to the contrary, central banks globally will be delivering interest rate gifts to the masses during 2024.
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