Fed & Co. Confront History of Mistakes

As the world’s major central banks near the end of their steepest rate-tightening campaign in decades, the harsh lessons of past policy errors will weigh heavily on decisions as to when and where borrowing costs peak.

In the coming two weeks, officials at the Federal Reserve, the European Central Bank (ECB), and the Bank of England (BOE) will decide how much more pain they need to inflict in order to restore price stability while trying not to send their economies off a cliff or push an already creaking banking system into crisis.

With credibility compromised by their slowness to detect the latest inflation outbreak, the trio of central banks will be desperate to avoid the mistakes of predecessors who bungled past monetary policy cycles.

For Fed Chair Jerome Powell, that means avoiding stop-go policies during the episode of Great Inflation that took off in the late 1960s. ECB President Christine Lagarde won’t want to repeat U-turns seen when price pressures were misread in 2008 and 2011. And BOE Governor Andrew Bailey will want to avoid being the “unreliable boyfriend” Mark Carney was once described as.

“The balance is not whether to over-tighten, but how much to over-tighten. Do you decide that’s enough, or do you keep going until something breaks? That’s a hard judgment,” said Michael Saunders, who was a BOE rate-setter until late last year and now advises Oxford Economics. “It’s a difficult dilemma … but no one becomes a central banker to win a popularity contest.”

While central banks will push higher, how long they stay there is a question even they have a hard time answering. No one knows how long it will take to put a lid on sticky services prices, or how fast the credit crunch will unravel demand.

 

The U.S. Federal Reserve

First up is the Fed this week, with a quarter-point increase—to a range of 5 percent to 5.25 percent almost fully priced in by futures markets. Up for debate is whether Powell and colleagues will then signal a pause.

Economists, including those at Goldman Sachs, have dropped forecasts for another increase in June, even as inflation remains far above target and calling a definite end to fighting it could risk up-ending public expectations about the Fed’s commitment to low and stable prices.

Jonathan Pingle, chief U.S. economist for UBS Securities LLC, expects the Fed will signal a pause, while adding that they’ll hike again if the data warrants it. He notes that the final hikes of the Fed’s past three cycles all came with a disclaimer that the next move was another increase rather than a cut.

And it looks like there’s more work to be done. The Fed’s preferred core gauge of prices, which excludes food and energy, picked up to 4.9 percent in the first quarter of 2023, the quickest pace in a year.

The Fed’s thinking will likely be informed by the long tussle to combat inflation from the late 1960s to the early 1980s, as well as efforts to avoid repeating what Wharton professor Jeremy Siegel once dubbed “the greatest failure of American macroeconomic policy in the postwar period.”

During that time, the central bank failed to prevent a wage-price spiral that helped send inflation into double digits. It took several attempts of raising and cutting rates, peak borrowing costs of 20 percent, and four recessions to finally get things back under control.

“We’re all very familiar, at the Fed, with the history of the 1960s and ’70s,” Powell said nearly two years ago when the central bank reaffirmed its ultra-easy policy. “We know that our job is to achieve 2 percent inflation over time.”

 

The European Central Bank

Officials at the ECB were even later than the Fed in starting their tightening campaign, and they still have a way to go until they reach the peak. Their May 4 decision is between a quarter-point or a half-point move. Policymakers have signaled that a terminal rate as high as 4 percent—compared with the current 3 percent—isn’t unrealistic.

While inflation across the 20-nation region has plunged over past months, the underlying trend is showing few, if any, signs of easing. Widening profit margins and generous wage deals are set to keep price growth elevated and ECB officials on their toes.

In judging their progress in tightening policy so far and weighing their next move, Lagarde and colleagues are acutely aware that their actions will be closely scrutinized in the light of past experience.

Jean-Claude Trichet, the ECB president from 2003 to 2011, raised rates abortively twice—in 2008 and 2011—only to find those hikes turned around within a few months. In the first instance, policymakers wrongly believed that Europe’s financial system wouldn’t suffer from turmoil in the U.S.; in the second, they underestimated the severity of the region’s debt crisis.

Fears of another U-turn following too much aggression have already started to build in the 26-strong Governing Council.

The account of their last meeting revealed that some members would have preferred a pause in tightening and a re-evaluation of the policy stance. “Past episodes were recalled in which the Governing Council had increased interest rates and then had to reverse the hike shortly afterward,” it said.

Florian Heider, a former ECB economist who is now the scientific director of the Leibniz Institute for Financial Research SAFE, says a rate cycle should have only one peak, “otherwise it will be a roller-coaster ride.”

 

The Bank of England

Policymakers at the BOE have come closest to taking a break, even signaling a pause is possible on May 11. But another stubbornly sticky inflation reading has traders preparing for more tightening.

On balance, the committee remains more worried about the inflation threat than the risk of squeezing the economy too hard. With the pace of consumer-price increases at over 10 percent, average regular pay growth above 6 percent, and the labor market still short around 200,000 workers compared with before the pandemic, there is work to be done. Deputy Governor Dave Ramsden has said ending the “inflationary mentality” is key.

On the other hand, the UK has just gone through the sharpest rate-rise cycle since the late 1980s. And with more households on fixed-rate mortgages, the policy lag is slower than in the past.

The pain is coming, BOE rate-setter Silvana Tenreyro argues, and tightening now is like Milton Friedman’s “fool in the shower”—so impatient for the water to warm up that he ends up scalding himself.

“The debate about policy lags is everywhere,” said Peter Schaffrik, global macro strategist at RBC. “Easing during the pandemic was a step too far, so they have to try very hard to get the genie back in the bottle. Some say they are seeing cracks. Others say ‘Hike until something breaks.’ That’s the battle raging between the two factions.”

While the BOE hasn’t made mistakes on the scale of those of the Fed and ECB in its 25 years of independence, it has had its fair share of communication stumbles.

One of which came just a few days ago, when chief economist Huw Pill told workers to “accept” that they are poorer and to stop asking for pay rises. Governor Andrew Bailey faced public ire with similar comments last year, as well as criticism from traders who have struggled to read his phrasing, leading to market volatility in the early months of monetary tightening.

Under his predecessor Carney, markets were repeatedly whipsawed by shifting communications. One episode in 2014, where he was forced to temper an earlier signal on a possible interest-rate increase, led lawmaker Pat McFadden to describe his mixed messages to investors as worthy of an “unreliable boyfriend,” a description that stuck.

 

Is It Better to Stay Hawkish or to Risk Stretching out Inflation?

With a hallowed “soft landing” looking ever less likely, Bailey, Lagarde, and Powell must all weigh the same question: Is it better to stay hawkish and plunge their economies into recession or signal a pause and risk stretching out the battle to contain prices.

“The general expectation is that rates will go up a bit more, central banks will lean back to watch the economy and see inflation loosening up,” said Klaus Baader, global chief economist at Societe Generale. “The risk is that we get a very different scenario. If core inflation doesn’t come down and a second tightening cycle is needed, there won’t be a dry eye in the house.”

 

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