Central Banking, Fast and Slow

By Mohamed A. El-Erian

CAMBRIDGE – Economic-policy discussions in the eurozone, the United Kingdom, and the United States increasingly revolve around the question of when and how quickly central banks should pull back the uber-stimulus measures implemented last year in response to the COVID-19 pandemic.

There are no easy answers. Both parts of the question call for finely balanced judgment calls to account for uncertainties that remain in play. Policy changes by major central banks can have far-reaching implications for economic and financial well-being, affecting not just those directly involved but also the many countries that will end up “importing” the effects of the decisions.

A simple way to frame the debate is to think of a road trip. In the car are two groups that agree on three things: the “destination” is to achieve high, durable, inclusive, and sustainable economic growth; the route to get there is far from straight; and the car has good forward momentum.

After that, the two camps disagree. One group believes that much of the remaining journey will be uphill and is therefore not too worried about the curves along the way. It would prefer to keep its foot on the accelerator, pedal-to-the-metal, lest the vehicle decelerate or stall.

The other passengers anticipate a downhill journey with many treacherous curves. With the vehicle gaining speed, this group would prefer to ease off the accelerator and avoid risking a sudden “economic handbrake turn,” as Andy Haldane, the Bank of England’s former chief economist, recently put it.

Whether you are an uphiller or a downhiller depends mainly on your assessment of three current issues: the labor market, the surge in inflation, and the risk of not being able to recover quickly in the event of a policy mistake.

The big labor-market puzzle is that, despite massive demand, the labor market is unable to match unemployed workers to jobs. The situation is particularly stark in the US. While Job Openings and Labor Turnover Survey data for April (the most recent available) show that there are a record number of job openings in the US – more than nine million – labor-force participation remains stubbornly low, and unemployment high, compared to pre-pandemic levels.

To explain this gap, some point to temporary and reversible factors such as school closures, enhanced unemployment insurance benefits, and insufficient childcare, whereas others worry about longer-term issues such as an altered propensity to work and skills mismatches. In any case, the labor market’s persistent malfunctioning – particularly employers’ struggle to find employees – is likely to lead to higher wage growth, a possibility that fuels concern about the second issue.

How “transitory” is today’s inflation? The pedal-to-the-metal camp has a surprisingly strong conviction that the current uptick in inflation will sharply reverse itself. As the year progresses, they expect base effects to wash out together with the supply and demand mismatches.

Others, including me, are not so sure, owing to the likelihood of persistent supply bottlenecks, changes in supply chains, and lasting inventory management challenges. We will probably need many more months of data before we can offer convincing assessments of these variables.

In the meantime, policymakers must be mindful of the risks associated with any given course of action – including inaction. In the face of such uncertainty, it is wise to ask not just what could go wrong but also what the consequences of a policy mistake would be. Under the current conditions, a wrong move could have far-reaching and lasting effects.

Those favoring a continuation of pedal-to-the-metal monetary policies argue that central bankers still have tools to overcome inflation should it persist. But as the downhillers are quick to point out, those tools have become increasingly ineffective and difficult to calibrate. As such, a central bank that falls behind may be forced to slam on the brakes, risking an economic recession and financial-market instability. The risk of inaction (or inertia) in this case may be larger than that of acting early.

In the current policy debate, this decision-making framework offers greatest clarity at the edges. For example, there is a compelling case for the US Federal Reserve to start easing its foot off the accelerator. Economic growth is buoyant, fiscal policy is also extremely expansionary, and businesses and households alike have significant accumulated savings that they will now be spending down. The conditions are now ripe for the Fed to start reducing – gradually and carefully – its bond-buying program from its current rate of $120 billion per month.

The European Central Bank, however, is in a different position. While eurozone growth is picking up, the level of fiscal support is not as strong as in the US, and the private-sector recovery is not as advanced.

The hardest case to call is the UK. With growth, fiscal support, and the private sector’s prospects more finely balanced, it is no wonder two highly respected central bankers, Haldane and BOE Governor Andrew Bailey, found themselves on opposite sides of the debate this month.

Other central bankers around the world may be tempted to think that they are simply spectators in all this. They are not. The Fed, the ECB, and the BOE are systemically important: their actions often have meaningful spillover effects (both positive and negative) on the global economy.

As such, central bankers elsewhere should be running their own scenario analyses and formulating appropriate response plans. There is nothing wrong with hoping that three systemically important central banks will get to their destination smoothly. But the journey is far from over, and the risk of someone slipping is not negligible.

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Mohamed A. El-Erian, President of Queens’ College, University of Cambridge, is a former chairman of US President Barack Obama’s Global Development Council. He is the author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.