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Are Central Banks about to make a major policy mistake?

Luke Suddards
Research Strategist
May 24, 2022
Central Bankers have some important decisions to make. In the below article I make the case for a looming policy mistake. Read below to find out more.

Inflationary fears are certainly weighing on the minds of central bank governors, this is evident in their recent rhetoric and actions which has become increasingly hawkish and ominous. However, they have to perform a balancing act of tackling inflation whilst engineering a soft landing on the growth and employment fronts. Very rarely has this been achieved. Given this, one has to ask the question are central banks about to commit a grave policy mistake, especially with many believing that the peak for inflation may be in. That could be the case for a number of reasons 1) the appreciation in USD should see higher imports as opposed to exports 2) the decline in risk assets such as equities will likely weigh on consumer spending through a wealth effect 3) higher gasoline prices 4) rising interest rates hitting mortgage demand. Achieving less demand growth, should translate through to weaker labour demand and price pressures should cool as a result. We’ve seen evidence from some of Wall Street’s behemoths such as Walmart, Target, Netflix and Amazon guiding to a murky employment outlook with slashes across headcount expected. Lastly, real time data on new job postings from Revelio showed a decline of 2mln. Additionally, this wasn’t concentrated to a handful of industries, but rather broad based across numerous industries.

To make matters worse G4 central bank governors are facing the heat for being too slow to begin policy tightening. Their credibility is being questioned and this could cause an over-reaction. In hindsight, they should have begun tightening policy gradually last year, but in their defence they couldn’t have predicted Omicron and a war. However, they should urge on the side of caution instead of moving from too slow to too fast now. Money markets certainly believe this could be the case with rate cuts being priced from Q2 2023 onwards.

So to answer the above question of are central banks making a policy mistake? In my opinion they are. I’m in good company with two Nobel prize winning economists Paul Romer and Joseph Stiglitz also supporting this argument. Get inflation down for sure, but the 2% target is outdated and needs to be adjusted higher in order to reflect the unique economic backdrop currently prevailing. How higher is the tricky part, for me, that would be around 3.5-4%. We adapted during the pandemic with things such as work from home, etc. Why can’t the Fed adapt? The problem for the Fed is that inflation is being driven by the supply side and their tools are suited for solving demand driven inflation. In order to bring supply and demand back into equilibrium and inflation back to 2% it will require significant demand destruction (hard landing), leading to lower growth and higher unemployment (Bank of England sees 600k job losses as the price to pay for taming inflation). If you asked the average person on the street would they rather pay slightly higher prices or lose their job, it’s pretty obvious what the answer would be.

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