Inflation: What Targets, What Risks?

Inflation disappeared from the radar of investors, consumers, and companies until 2021, but then came back sharply and unexpectedly in 2022 due to rising gas and oil prices caused by simultaneous expansionary fiscal policies around the world (to respond to the pandemic-induced recession) and tensions caused by Russia’s invasion of Ukraine. Central banks have reacted late to the 2022 shock (especially the ECB) and are still following the traditional approach that identifies 2% as the long-term inflation target that still serves as a trend benchmark, around which to measure the likelihood of short-term interest rate cuts. What are the chances of interest rate cuts expected by the market in 2024? Are they in line with growth projections? What limits to managerial freedom do central banks have?

Growth forecasts for 2024: in the July update, the International Monetary Fund forecasts global growth at 3.2% in 2024 and 3.3% in 2025, but this should weaken in the medium term due to the structural slowdown taking place in China. From a global perspective, an additional element of risk comes from Russia and the lowering medium-term growth of the economy, which has decided to shift the allocation of its resources towards arms production, sacrificing, among other things, investments in technology and training. The USA is down slightly from April estimates of 2.6% and 1.9%, while Europe seems to be recovering with 0.9% and 1.5%, primarily thanks to Germany and despite lower forecasts for Italy of 0.7% and 0.9% respectively. Therefore, in relative terms (between countries), there is not much new here, even though the overall growth context seems to be weakening over the medium term.

Structural elements of the slowdown: during this period, we often focus on the potentially negative impact on interest rate hikes and try to formulate monetary policy projections (discussed below), but we forget an essential element: we are in one of the most expansionary periods in the history of fiscal policy. An example is Italy, where the public deficit exceeds 7%, and the debt-to-GDP ratio will again exceed 140%. The coexistence of government deficits at 7% of GDP with a growth rate of less than 1% is truly amazing. Although academic research has revised estimates of the Keynesian income multiplier downward, we tend to think that deficits create aggregate demand that drives companies to produce goods and services. With slightly rising consumption and a good trade surplus, where does the impact of government spending and transfers disappear? Is the revenue multiplier gone? Although in other proportions, the relationship between government spending and economic growth also seems to have deteriorated over time in the United States. Maybe the problem is that government spending is not being used to build infrastructure and human capital?

2024 interest rate and inflation forecasts: bond markets expect two interest rate cuts in Europe, in September and December, and are increasingly uncertain about what the Fed will do, which, on the one hand, is beginning to see signs of slowing growth and inflation and, on the other hand, wants more certainty about the return of inflation. Thus, in the Atlantic comparison, the first signs of monetary policy heterogeneity due to short-run divergence in growth and inflation appear. The medium-term inflation scenario is perhaps less optimistic than the one envisioned by financial markets. The International Monetary Fund itself notes the dynamics of wages and prices in the services sector as elements of attention. To the factors that could cause medium-term inflation to exceed 2% we can add a reduction in international trade caused in the short term by tariffs and in the medium term by increased costs of transporting goods and people, as a result of internalizing the costs of CO₂ emissions. This last point deserves a little in-depth analysis: the European Green Deal puts our continent at the forefront of global efforts to change the overall system of production of goods and services, and the Greens’ recent support for Ursula von der Leyen’s re-election may strengthen, rather than weaken as the election results suggested, Europe’s commitment to sustainable development (as ironical as it is in a world where the real surge in production has come from arms production, with an impact of CO₂ emissions in Ukraine, in the first 18 months of war equal to what a country like Austria or Portugal produced in a year – see here for more details). The rational outcome of efforts to restructure energy sources in favor of less polluting sources can only result in increasing the cost of energy supply in the short term with structural effects on inflation (especially for Europe, given the energy self-sufficiency of the United States).

Decisions and strategy with a question mark from the ECB: the ECB did not touch interest rates at its July 18 meeting. This is great news as expectations have been met. The justification argued that “the inflationary impact of wage increases has been absorbed by profits, while at the same time service price increases remain high, and the overall inflation rate will remain above 2% until 2025.” The ECB also confirmed its identity change from Mario Draghi’s direct leadership to “Christine Lagarde’s data-driven and meeting-by-meeting approach.” In short, just when a strategic vision closely integrated with fiscal policy will be needed to steer the European economy towards an economically sustainable future, our central bank is diving into a short-term response to economic dynamics, while at the same time reaffirming its determination to bring inflation back to 2%. The lack of a common vision and reflection on how to guide the European economy in a difficult situation is not encouraging for businesses, citizens, and investors.

Conclusions: the growth situation is slowing down very moderately, and central banks (let’s not forget) have managed to normalize interest rates through the fastest and most intense increase in history without significantly damaging the financial structure. This opens up important options for lowering rates to address the economic downturn, but only if inflation returns to the 2% target. However, this return has no wind in its sails. During the last periods of Mario Draghi’s presidency, a debate started regarding the possibility of raising the inflation target above 2%. Isn’t it time to discuss this issue again?