“The Fed lost their bet”

James Bullard, head of the regional Fed branch in St. Louis, made a similar statement. Overall, Posen believes, the Fed needs to raise interest rates from zero percent to 2 percent to fight inflation and bring the economy back into balance.

In the worst case, if prices continue to rise stubbornly, four percent could also be necessary. That would be a serious drag on the economy; Economic recessions, i.e. phases in which the economy shrinks, have often been initiated by interest rate hikes by the Fed in history.

Posen is undecided on whether these rate hikes should come in half-point or quarter-point increments. The major US bank JP Morgan recently increased its forecast from five to seven interest rate hikes by a quarter of a percentage point in the current year. It sees three further steps for 2023, which would then correspond to an interest rate level of 2.5 percent. The Fed expert there, Michael Feroli, considers an increase of 0.5 percentage points in March, as suggested by Bullard, to be rather unlikely.

Poznan considers the labor market to be an important driver of US inflation. However, he does not believe that the increase in wages there, which is mainly due to frequent job changes, will have to become permanent. Overall, he still believes inflation would fall even without Fed action, but only to maybe 5 percent.

With regard to the European Central Bank (ECB), Posen says: “The situation in the euro area is completely different from that in the USA.” than in the USA: “Not that much tightening is necessary there.” In Europe, energy prices are the driving factor, and they cannot be influenced directly by the ECB. Rising wages can hardly be observed, and fiscal policy is less aggressive than in America.

The economist also understands that the ECB supports the heavily indebted euro countries such as Italy, Spain and Greece. ECB President Christine Lagarde has promised that this will also be possible in the future under the PEPP emergency program, which allows the targeted purchase of interest-bearing securities from individual countries.

Purchases under PEPP are to be discontinued in the coming month, but expiring papers will continue to be replaced. The ECB justifies such flexible purchases with the need to make its monetary policy effective in all parts of the euro area.

This policy is often criticized as covert state financing. Posen, who worked at the Bundesbank in Frankfurt in the 1990s, says in a mixture of English and German: “The ECB is a little bit smart.”

He thinks she should keep doing it. Robin Brooks, chief economist at the major banking organization IIF in Washington, warns that the ECB has recently financed practically all of Italy’s new debt.

In case of doubt, he calls for the program known by the acronym OMT to be used. According to this, the ECB can buy bonds in a targeted manner if a country has officially applied for a support program from the EU, which would largely place the respective government under supervision. Posen thinks nothing of that. “The conditions make the deployment impossible, especially since the governments of the federal states have been doing business sensibly recently,” he says.

Looking at the US, Posen concedes that the Fed’s new strategy may have made “some contribution” to the delay in the monetary policy turnaround. According to the concept announced in late summer 2020, which Poznań described as a “historic moment for monetary policy”, the central bank can also tolerate exceeding the inflation target of two percent for a long time if the price increase has previously been below the target for a correspondingly long time.

The Fed has also made it a point to pay more attention to the issue of unemployment and only fight inflation when it’s actually there – not when it’s to be expected.

Posen had previously suggested raising the inflation target in the US to three percent. In the period of very low price increases after the great financial crisis of 2008, this was a catchy concept: it was supposed to bring nominal interest rates to a higher level at the same time as inflation.

The real interest rates, calculated after deducting inflation, would therefore not have risen. However, the central bank would have created more leeway to push the real interest rate below zero in order to support the economy.

From today’s perspective, Poznan is moving away from this. “I’m surprised at how violently Americans are reacting to inflation after more than 25 years of low inflation,” he says. “That’s why a higher inflation target would not be politically feasible.”

Although American society is politically deeply divided between supporters of the Republicans and the Democrats, that makes little difference when it comes to inflation, he observes: “Supporters of both parties get upset about it.”

In the US, there is a lively discussion, initiated very early on by Blanchard, the former chief economist at the International Monetary Fund (IMF), that the generous spending of the ruling Democrats under President Joe Biden is partly responsible for the price hike. Inflation is also seen as a potential burden for Democrats in the upcoming congressional elections this fall.

In addition to interest rate hikes, the Fed has also announced a shrinking of the balance sheet total by no longer fully replacing maturing bonds with new purchases. This is changing the conditions on the bond market, as Mohamed El-Erian warns.

While investors there have so far been supported by a powerful buyer in the background, this buyer will be absent in the future. However, Poznan considers the consequences of this reduction in the balance sheet to be very limited. “Bond purchases have a great effect in times of crisis, but this does not apply to sales outside of crises,” he says. “The liquidity is lacking in the crisis, but now we have enough of it.”

However, he concedes that many economists and central bankers disagree on this point and consider the sheer size of the central bank balance sheet, even if it is not growing, to be a significant, expansionary monetary policy factor.

Posen doesn’t believe that the reduction in total assets will boost US yields much. There are other opinions on this as well. Ray Dalio, founder of the Bridgewater hedge fund, fears that inflation will persist and investors will lose interest in bonds even more. If that happens, he notes in a LinkedIn post, “enormous amounts” of bonds could be sold – with prices falling and yields rising as a result.

More: “Plenty of room for rate hikes” – Fed Chair Powell primes markets for significant turnaround