Central banks vs. full-employment disinflation - 19 June 2023
Central banks have confirmed that disinflation does not necessarily mean a fall in interest rates. A rare phenomenon, this is disinflation in the developed world with almost full employment.
Despite good inflation figures in Europe and the US in May, the US Federal Reserve and the ECB stood firm. Powell hinted at the possibility of one or two more rate increases by the end of the year, and Lagarde suggested that the ECB deposit rate could soon rise to 4%, compared to today’s 3.5%. Having been positioned around a near-peak scenario for several months now – expecting a decline in interest rates from the end of the year, bond markets were taken by surprise, especially on the short end of the yield curve (Chart 1).
As we have often highlighted, bond markets cannot benefit from a disinflation that they have already widely anticipated. As for real rates (i.e. after inflation), there is little reason for these to decline in a resilient economy whose prospects are improved by the distribution of purchasing power that disinflation allows.
Finally, the ongoing fairly low level of short-term real rates and the historical employment situation are prompting central banks to remain wary. The average unemployment rate in G7 countries has recently fallen below 4% – a scenario that has not been seen since 1975 (Chart 2). This is of course excellent news, but the idea that there is a trade-off between inflation and unemployment remains fairly entrenched in the minds of economists and central bankers. Economics students who have encountered the Taylor Rule would explain that given current levels of inflation and unemployment, central bank interest rates seem far too low.
Taylor’s rule comes from economist John Taylor, who identified a seemingly stable relationship between interest rates, inflation and unemployment in the early 1990s. If applied today, Taylor’s model would mean the Fed setting interest rates at around 10%, which is obviously unthinkable. Many other versions of this rule have been proposed, none of which have secured universal agreement. But they mostly indicate a theoretical Federal Funds Rate of above 5% (see the ‘Taylor Rule Utility’ webpage on the subject by the Federal Reserve Bank of Atlanta).
Here, we are faced with a paradox. Current full-employment disinflation is the best economic news we could hope for. But with underlying inflation still well above 2%, unemployment at a fifty-year low and real rates still low, central banks are struggling to believe that their policies are sufficiently restrictive.
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