Lessons from the tough fight against inflation

Unlock Editor's Digest for free

FT editor Roula Khalaf selects her favourite stories in this weekly newsletter.

Dubbed the Davos of central bankers, the annual Jackson Hole summit, which begins Thursday, brings together the world's top macroeconomists in the mountains of Wyoming to discuss monetary policy issues. The summit may not be as glamorous as its fancy Swiss counterpart, but because the discussions influence thinking about interest rate policy and inflation, it can be more consequential for the global economy.

At last year's symposium, central bankers from developed countries had made significant progress in battling inflation, but were far from confident that they had defeated the beast. This year, the tone will be different. Price growth is moving closer to inflation targets and major central banks have already started or are about to cut interest rates. Price pressures are now less of a concern than supporting the slowing economy. All eyes are on Federal Reserve Chairman Jay Powell's speech on Friday, which may provide clues about the American rate-cutting trajectory.

Monetary policy experts are not known for their party spirit, but the changed circumstances since the last summit are cause for celebration. Price growth has so far fallen without unemployment rising significantly, a rarity in rate-hiking cycles. Central bankers may have been lucky: Food and energy price pressures proved largely temporary, and the labor hoarding dynamics of the post-pandemic economy meant that employers were more inclined to create vacancies than jobs. Still, high interest rates helped stabilize inflation expectations and curb demand.

However, it has not been a flawless rate-hiking cycle. Central bankers were initially too slow to raise rates, perhaps failing to recognize that the feedback from higher rates to the real economy had weakened during this cycle for a number of reasons. Indeed, at this year's summit – which will appropriately focus on “monetary policy effectiveness and transmission” – central bankers should reflect on the lessons they learned from the upswing to manage the downswing.

What could they learn from this? First, central bankers need to better understand the lags in monetary policy. The predominance of fixed-rate mortgages in some economies meant that the impact of higher interest rates was felt with a long and possibly underestimated lag. This should also be taken into account when cutting interest rates. Households that will soon need to take out a new mortgage could still see a significant tightening of their finances if they had locked in before the rate rise, even if rates are now falling.

Second, rate-setters need to be more aware of local economic dynamics that can affect the assumed relationships. For example, the Phillips curve model – which correlates lower inflation with higher unemployment – has not been reliable in this cycle. This is partly due to the peculiarities of the post-pandemic labor market, such as labor hoarding, changing work preferences and higher inactivity, which many monetary officials recognized too late. Savings buffers and markets flooded with liquidity also limited the impact of higher interest rates.

Third, effective communication is essential. Central bankers need to make clear that a “data-dependent” approach means focusing on a body of data rather than individual data points, as Powell recently explained. Inconsistent and sometimes unreliable economic data have made market expectations particularly volatile this cycle. In the future, placing more emphasis on a broad data base and the overall outlook could help policymakers better manage markets.

These lessons underscore the complexity and hence the limits of monetary policy. Central bankers still have a lot to learn, but they cannot keep prices stable on their own. If interest rates remain too high for too long, there is ultimately a risk that the economy will be overstretched. Governments that have fuelled inflation through high deficits and a lack of housing construction must also do their part.