The US and Europe should separate on monetary policy

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After a pandemic, war in Europe, and the worst global inflation in 40 years, central bankers are fully justified in taking a safety-first approach. Aiming to optimize economic outcomes has taken a back seat to risk management. The big question this summer is how officials can best set monetary policy with risk management in mind.

To assess the economic evidence, central bankers first need to be clear about which risks they are managing. All that matters is economic activity, inflation, and things that affect people's lives. All too often, central bankers say the worst outcome is to start a floating period and then change your mind. This may be difficult given personal reputation, but it costs little to society. If we go down the path of always having to be sure before deciding to change interest rates, we will definitely delay changes in interest rates. This may result in others incurring substantial costs.

The question in the United States and Europe is how much and how quickly to lower interest rates. Too much could create unsustainable demand and undermine the success of defusing inflation. But being too cautious risks pushing the economy back into a pre-COVID-19 world of insufficient demand, below-target inflation, and further reliance on unconventional monetary policies such as quantitative easing. . Ironically, this is the scenario they least want, so hawkish central bankers should do their best to avoid it.

An interesting current phenomenon is that after a series of global shocks, risk management suggests that it is time to decouple monetary policy on both sides of the Atlantic.

Domestic demand is strong in the United States. Headline GDP data for the first quarter came in at a disappointing 1.6% annualized growth, but that doesn't reflect domestic spending. Final sales to domestic private buyers (a better indicator of demand) grew at a 3.1% annualized rate, much of which was funneled out of the U.S. economy via imports. Savings rates are near historic lows.

In other European economies, such as the eurozone and the UK, the situation could not be more different. Households are experiencing an even more severe income shock due to rising heating and electricity costs following Russia's invasion of Ukraine, and household consumption is slumping. Savings rates remain high, creating the threat of a lack of demand. Even though energy costs are currently falling, real levels of spending and investment have not risen correspondingly.

While estimates of the output gap have been significantly revised and are therefore best taken with a grain of salt, they represent a similar picture across the Atlantic. The IMF believes there is a positive gap in the US, indicating continued inflationary pressures, but negative gaps in the euro area and the UK.

Governments around the world are also trying to separate the United States from Europe. In Europe, budget deficits have declined and are expected to decline, while in the United States, deficits are expected to remain high. Both of these may be based on heroic assumptions, but it is clear that the US fiscal impulse is stronger.

Labor market data are closer between the US and Europe, but the picture regarding risk remains the same. Low unemployment and weak productivity growth are more likely to reflect labor hoarding in the face of weak demand than persistent supply-side issues. If demand in Europe is strong, there is scope for significant productivity gains.

Given that the positions of the US and European economies are so different, their assessments of policy risks should also be fundamentally different.

The conventional wisdom in the United States is that the Fed needs more reassurance about defusing inflation before it eases the pressure it is putting on the economic brakes this summer. This is a wise thing to do. There were few signs of an economic downturn, and while the latest inflation figures were reassuring, they did not provide reassurance that price increases were stabilizing near the central bank's 2% target. Annual core CPI inflation was 3.6% in April, with most of the price increases occurring over the past six months rather than before.

If there is enough evidence that inflation is falling, the Fed can ease monetary policy with little risk, but there is also little risk of loosening monetary policy until the fall.

Europe, by contrast, needs stimulus. Inflation has been steadily declining and forecasts suggest that wage pressures in the euro area will also ease on schedule. The UK has been slow to come down, but with headline inflation falling to nearly 2% in April, it will become harder to justify excessive wage demands later this year.

The central risk in Europe is that monetary policy remains too tight, undermining the necessary recovery in demand towards pre-pandemic trends. Central banks on the continent should follow the example of Sweden and Switzerland and begin interest rate cutting programs. The ECB has indicated it intends to take the first steps in the coming weeks. It would be wise to continue.

Although there is no stipulation that interest rates must move in sync among the world's major developed countries, global forces have brought countries into line this century. The point of independent monetary policy is that officials make policy decisions without thinking about their own government or the Federal Reserve.

chris.giles@ft.com