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The writer is president of the Peterson Institute for International Economics
With the European Central Bank and the Bank of Canada cutting rates this week, attention has now turned to the US Federal Reserve and its stance of keeping rates “higher for longer”. But we should not lose sight of the bigger picture of monetary policy. The more we look at how similar interest rate policies have applied to very different economies, the more we have to wonder how similar the outcomes are.
Since the shock of Covid-19, followed by the Russian invasion of Ukraine, the Eurozone, the US and, for that matter, Canada, the UK, Brazil, Mexico and most other major monetary areas (with the exception of Japan) have been on roughly the same path of inflation and interest rates. Team Transitory could argue that these were global shocks and therefore this similarity was only to be expected. But that is downright misleading. Yes, the shocks were global, but the common path followed by most means that several other important economic factors appear not to have mattered. That is striking and important.
Consider the following differences between the Eurozone and America. The US exports food and energy, Europe imports them; the US exports weapons and ammunition, Europe imports them; the US is an ocean away from the war zone in Ukraine, the EU absorbs millions of refugees and faces open risks. Or take the pandemic. During this period, unemployment in the US rose above 20 percent, while in the EU it hardly rose, due to fundamental differences in labor markets and support policies. After initially taking similar positions during Covid-19, the US sustained the big fiscal expansion for much longer than Europe. Finally, the euro is not nearly as widely used in trading, financial, or reserve portfolios as the dollar.
In the US, the propensity of households to consume and borrow is much greater than in the eurozone. This is reflected in the rapid decline in excess savings built up during the pandemic. Meanwhile, commercial and real estate lending in the US has migrated from traditional banks to largely unregulated private lenders to a much greater extent than in Europe.
One would expect that variations in firm concentration and antitrust policies between the two regions would lead to differences in their price-setting behavior. And while organizing has become stronger in the US recently, unions and collective bargaining still play a much larger role in European wage setting. But for all this potential to divert countries from a common path, interest rate moves of similar size and pace by central banks on both sides of the Atlantic apparently had the same effect on inflation, with roughly the same lag in both.
Do differences in labor market institutions, fiscal paths, or even labor productivity really make no difference to monetary transmission and the persistence of inflation? That’s what many modern monetary theories tell us. In our 1998 book Inflation targetingBen Bernanke, Thomas Laubach, Frederic Mishkin and I essentially said that if an economy establishes an independent central bank with a transparent low-inflation target, this would anchor longer-term inflation expectations. This in turn would mean that monetary policy could respond flexibly to short-term shocks, while inflation would still return to target if policy remained consistent.
This has become apparent over the past four years. And this is so despite differences in national economic structures and the ways in which monetary policy works its way through each system. A recent series of central bank research papers, applying the model developed by Bernanke and Olivier Blanchard for the US to their own economies, has produced similar results. Although the differences in the labor market turned out to be statistically significant, they were of second order. Overinterpreting such small differences in the persistence of inflation would only result in a counterproductive refinement of policy.
What have we learned in recent years? We have learned that people in high-income democracies still hate inflation, so this monetary regime appears to have significant political legitimacy. There is a parallel here with the “end of history” argument about liberal democracy after the fall of the Berlin Wall in 1989: there are really no credible alternative monetary regimes.
Independent central banks and low and transparent inflation targets are a great combination. That is why all major economies, with the exception of China, and the vast majority of high- and middle-income economies have adopted it. While autocratic leaders in India and Turkey have leaned on their central banks and cut interest rates despite rising inflation, they have paid a clear price.
This does not mean that there will not still be inflationary shocks and competition for scarce resources, just as the supposed end of history has not eradicated war and ethnic conflict in the political sphere. Monetary history continues – sort of. But we should pay more attention to the similarities in central bank policies in recent times than the current discussion seems to do.