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Even central banks do not know exactly when they will stop raising rates

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The Conversation

José Luis Álvarez

Associate Dean of students, School of Economics

Inflation has begun a gradual decline on both sides of the Atlantic in recent months. Faced with this slowdown in prices, one question arises almost automatically: when will central banks stop raising interest rates? It is not clear, but we can give some clues as to why this is the case.

The objectives of central banks

The actions of central banks can only be judged, understood and anticipated in light of the objectives assigned to them. Both the US Federalreservation and the European Central Bank (ECB) have the mission statement priority of ensuring price stability. The other central banks share the same goal.

In operational terms, this mission statement means keeping the inflation rate at a low and stable value, which is normally around 2%. In other words, a rate that all economic agents can live with without having to worry about paying attention to it.

Although fees inflation rates have fallen recently, they are still far from the goal mark. According to the European statistical agency Eurostat, the inflation rate in the euro zone was 5.5% in June.

In the United States, the rate of price growth stood at 4 % in May 2023. Moreover, core inflation, which excludes unprocessed food and energy prices due to their high variability, remains in both cases at around 5.5 %. The signs show, therefore, that inflation is proving difficult to break.

Signal arrives with delay

This resilience of inflation suggests that interest rates will have to keep rising. The argument is simple. If we see that prices continue to rise at an excessive rate, we will have to step on the brakes further. In other words, interest rates must be raised further to discourage demand for credit and thus reduce household consumption and business investment. Cool down expense and Economics. This would be the appropriate monetary policy.

Sounds easy, doesn't it? But it is not, because Economics does not drive like a car. The difficulty lies in the delays with which monetary policy works. A more apt simile than that of driving a car would be that of driving a Martianrover from Earth.

The signal reporting what is happening on Mars arrives on Earth several minutes late. The same is true for the signal from here to guide the rover. If we tried to control the rover as if it were a car, we would cause a disaster. We would press the controls again and again expecting to see an immediate reaction from the rover. But this would not happen and we would insist with the controls. After a few minutes, we would realize that our frantic activity would have taken the rover far away from where we wanted it to go.

Decision and prudence to gain confidence and credibility

Something similar occurs with monetary policy. This policy is transmitted to Economics through long, complex channels that are subject to changes that are difficult to anticipate. For this reason, central banks must act decisively but prudently. They are obliged to continuously interpret what is happening, to try to distinguish the effects of their policies in the midst of a changing environment.

Faced with this challenge, they must also generate confidence and gain credibility. Otherwise, they may provoke reactions in the markets that could jeopardize their objectives.

In the current inflation scenario that is no easy task: the costs of rate hikes are quickly felt, for example in mortgages, while the benefits in the form of price containment take longer to manifest themselves. This is a breeding ground for social discontent.

As if these difficulties were not enough, two different sensitivities coexist in each central bank. On the one hand, there are the hawks, who participate in decision-making by being intransigent on inflation. On the other hand, there are the doves, who show a little more tolerance towards inflation in the interest of preserving growth.

The harshness of this inflationary episode has logically led the hawks' views to prevail. However, as the costs of the rate hike accumulate, the voices of the doves are beginning to be heard.

What signals are currently emitted by the Economics

The signals coming from Economics do not make the picture much clearer either. We see that growth has been slowing down in Europe. A country as important as Germany has entered a technical recession, even dragging the eurozone with it.

The United States is also experiencing this drop in growth, although in the first quarter of 2023 it has grown more than had been estimated. At the same time, the labor markets in the United States and the euro zone appear to be under stress. They present fees unemployment at really low levels and many companies are having trouble finding the staff they are looking for.

Labor market tensions are of particular concern to the Federal reservation and the European Central Bank. Higher wage costs may fuel further price increases by companies in an attempt to cope with higher costs and preserve their margins. This is the dreaded inflationary spiral.

What to expect (in the short term deadline)

Against this backdrop, the latest statements from the heads of the reservation Federal Reserve and the ECB augur further rate hikes in the coming months.

Both Powell and Lagarde have insisted that reducing inflation is an arduous task that requires firmness. But central bankers are also beginning to suggest that the rate ceiling could be near, in late 2023 or early 2024.

This status is reminiscent of a large ship approaching port. It must slow down from a distance B. If it does not do so correctly, its inertia could end up causing chaos in the port. Or it could stall before arriving, forcing a more complicated maneuver.

The problem for central banks is that they know what port they want to reach (a stable leave inflation rate). But they don't know exactly where it is. Moreover, the confusing signals emitted by Economics make it difficult to establish precisely the speed at which to navigate.

The next few months will be decisive in clearing up these uncertainties. In the meantime, central banks should remain cautious, with small rate hikes, as they have been doing more recently.