On Thursday, September 12th, the European Central Bank announced its second interest-rate cut this year:
The Governing Council today decided to lower the deposit facility rate—the rate through which it steers the monetary policy stance—by 25 basis points. Based on the Governing Council’s updated assessment of the inflation outlook, the dynamics of underlying inflation and the strength of monetary policy transmission, it is now appropriate to take another step in moderating the degree of monetary policy restriction.
In other words, the ECB’s lead interest rate is now down from 3.75% to 3.5%. This decision comes almost to the day a year after the ECB raised the same rate from 3.75% to 4%, where it remained until June this year.
Unlike the Federal Reserve, the ECB has gradually rolled back the tighter monetary policy it introduced in response to the rapid inflation surge in 2021. As Figure 1 shows, it is unusual for the ECB to precede the Fed with its monetary policy: normally, it is the American central bank that makes a policy move and its European counterpart that follows suit.
However, Figure 1 conveys another, more important point about monetary policy. Look at the ‘gap’ between the high interest rates in 2006-2008 and the return to high rates in 2022. In America, this gap breaks down into three episodes, the so-called Quantitative Easing under Fed Chairman Ben Bernanke (1), the monetary tightening under Janet Yellen, and the pandemic-response return to very low rates (2) under Jerome Powell, the current chairman of the Federal Reserve.
In Europe, on the other hand, the period with very low interest rates was one long episode (3):
Figure 1
When these two central banks started raising interest rates again, it was generally reported as an extraordinary measure to fight inflation. While correct per se, it was also a return to more normal monetary policy:
- The Federal Reserve raised its federal funds rate to approximately where it had been some 15 years earlier;
- The ECB pushed its deposit facility rate about one percentage point higher than its top in 2006-2008.
The Fed tried to normalize its funds rate in 2016-2018, but when Janet Yellen’s term ended President Trump chose not to re-nominate her. Unlike her successor, Jerome Powell, she would not listen to his criticism that interest rates needed to be lower.
Yellen was right: interest rates neither need nor should be as low as they were during episodes (1), (2), and (3). There are numerous problems with rates this low, problems that we need to keep in mind now that our central banks are once again lowering their policy-setting interest rates.
One of the problems with low interest rates is that they create cheap credit. When households and businesses can access loans in abundance, they invest in equity markets, primarily real estate and stocks. The prices—values—on those markets then rise faster than their productive value would merit, hence causing a speculative bubble. The end result is increased volatility and a high risk for contagion effects throughout the economy.
Furthermore, low interest rates encourage governments to spend excessively on borrowed money. If these budget deficits are then monetized by central banks, we have the most dangerous recipe possible for high inflation.
At this point, there is zero risk of renewed inflation from deficit monetization. However, if the ECB and the Fed engage in a long series of rate cuts, we will eventually return to the point where it is politically much cheaper for lawmakers to borrow money than to fund government through taxes. Once we reach that point, it is time to revisit the risk of another inflation episode.
Meanwhile, the big question for next week’s meeting with the Federal Reserve’s Open Market Committee is: by how much will they cut their federal funds rate?
The answer lies in part in what just happened to the consumer and producer price indexes, CPI and PPI, or consumption and production prices. This week’s CPI shows an annual inflation rate of 2.53%, which was a healthy drop from 2.89% last month. However, I do believe this is an aberration, not a trend-driven decline in inflation. The activity level in the U.S. economy remains too high to allow for this kind of cooling-off of consumption price inflation.
Producer prices fell by 0.8% year-over-year. This marks a return to PPI deflation after four months of rising producer prices. However, this downtick is likely a statistical exception, part of a pattern of volatility in producer prices that is not present in consumer prices.
If I am correct, then what we will see in the coming months is a less aggressive version of Trend 1 in Figure 2:
Figure 2
Consumer prices are closely tied to producer prices, but usually with a margin of two months.
If the Federal Reserve fears Trend 1, then there will only be a 0.25 percentage point reduction in the funds rate at next week’s FOMC meeting. If, on the other hand, the Fed has come to the conclusion that we have returned to an era of price stability, then they will assume some version of Trend 2 and will likely cut the funds rate by 0.5 percentage points.
