Central Banks face a new economic regime
2023.01.12 06:44
Central Banks face a new economic regime
By Ray Johnson
Budrigannews.com – Market interest rates were falling, inflation was low, globalization effectively increased the supply of labor, and, at the margin, markets for goods and services were becoming more open and stable for roughly 30 years, making it a favorable environment for policymakers at the Federal Reserve and other central banks.
The COVID-19 pandemic has disrupted those trends, if not completely upended them, in a way that risks confusing policymakers about what to expect.
One unexpected set of changes that the U.S. central bank is already adjusting to is an outbreak of inflation in conjunction with stagnant labor force growth. But it could just be the beginning of a long discussion about how economic dynamics have changed, making it hard for central bankers to keep up and learn more about things they have never done before, like the supply side and industrial organization economics.
“Identification becomes something of an art form,” Atlanta Fed President Raphael Bostic said last Friday on a panel at the annual meeting of the American Economic Association (AEA) in New Orleans. Economists sometimes describe the kinds of changes that may be taking place in terms of a new economic “regime.”
“You have to identify the regime change… Then you have to understand the dynamics of the transition… and have a clear vision and insight into all of those… It becomes a very, very difficult challenge to try to develop a single or unitary view that represents a consensus.”
According to Bostic, he already believes that the U.S. labor market has likely changed permanently, resulting in an apparent labor shortage and a population that is making new decisions about work, leisure, and retirement.
However, the structural gap might be much deeper.
New geopolitical risks posed by Russia’s invasion of Ukraine and China’s uncertain position in the world following the pandemic were discussed on the AEA agenda in New Orleans, which may prove to be the tip of the iceberg.
Manufacturers who are reluctant to rely as heavily on China or who desire greater resilience overall may recast supply chains built around relatively frictionless global trade in more expensive ways; It may be necessary to accommodate higher debt levels and interest rates in financial markets that are based on anchored low interest rates and a global surplus of savings; Another factor that may be contributing to higher prices is adaptation to climate change, whether it be to reduce damage or switch to lower-carbon alternative power sources.
In a panel session at the AEA meeting on Saturday, Kenneth Rogoff, a former chief economist at the International Monetary Fund who now teaches at Harvard University, stated, “We may well be at a turning point in the global economy.” Markets that have been calibrated to… the growth of China and low interest rates may prove to be fragile.”
Kristin Forbes, a professor at the Massachusetts Institute of Technology and a former member of the Bank of England’s Monetary Policy Committee, stated on the same panel as Rogoff that even the most recent year saw unprecedented joint losses in major stock and bond indexes. This correlated downturn challenged the fundamentals of portfolio management and ought to prompt extensive new research on how to prepare for future crises.
Other economic turning points aren’t always obvious at the time, like recessions, which typically aren’t noticed until much later.
Data from the 1990s didn’t show much of a shift toward higher productivity, but then-Fed chief Alan Greenspan insisted it was happening and correctly predicted that inflation would stay lower than expected, necessitating lower interest rates.
In contrast, former Fed Governor Randall Kroszner claimed that the industry was unaware of the ways in which shifts in the mortgage markets in the United States had enabled broader risks to the financial system to accumulate and eventually break it.
In an interview with Reuters, Kroszner, an economics professor at the University of Chicago Booth School of Business, stated, “Policy has to be made in real time.” It is very important to be humble and realize that the models you are using and the data you are relying on might not be right for the future.”
Institutions like the Federal Reserve can take time to adapt, even when it is obvious that changes are taking place.
For instance, it had long been suspected that the so-called neutral rate of interest, which is the point at which economic activity is neither constrained nor stimulated, was falling, which would theoretically enable the Fed to maintain a lower policy interest rate.
However, despite the fact that the evidence of that accumulated during the recession that occurred between 2007 and 2009, it was only incorporated into Fed policy in 2020 under a new strategy that leaned against premature interest rate increases.
That occurred just in time for what may prove to be yet another shift in a different direction as the Fed now faces a world with limited supply and prices that are too high for comfort rather than a persistent lack of demand and low inflation.
To address inflation, for instance, Fed officials have begun to toss around new research lines and theoretical frameworks.
Neel Kashkari, president of the Minneapolis Fed, compared recent inflation to “surge pricing” models used by tech companies like Uber Technologies (NYSE:). Speaking on a panel at the AEA meeting last week, Fed Governor Lisa Cook laid out the beginnings of an agenda to overhaul the Fed’s understanding of pricing dynamics and their impact on monetary policy.
She suggested that this would include utilizing “real-time and other novel indicators” to enhance inflation forecasting. There is no such thing as too much data or analysis when a once in a century event disrupts the economy.
Behind everything: A growing focus on the economy’s supply side, which monetary policymakers typically consider to be a “given” because their main tool, interest rates, work to encourage or discourage spending or aggregate demand.
The ability of the economy to provide goods and services may be beyond the immediate control of policymakers and more dependent on factors like immigration, regulatory policy, or, more fundamentally, the quality of the country’s education system and the skills of its graduates.
However, Bostic stated, the pandemic has demonstrated that policymakers cannot ignore it.
Bostic told reporters in Atlanta on Monday, “We learned that supply shocks can endure for quite some time in a way that I don’t think our conceptual frameworks really embraced.” “I think we do need to understand how goods get made and how our systems make it easier or harder,” is the top priority for dealing with the emerging economy.
More Bank of Japan is experiencing difficulties due to rising inflation
