Uncertainty and monetary policy

Manuel Aguilera, General manager at MAPFRE Economics

The monetary tightening measures put in place to curb inflationary pressures are beginning to show results, and, as a consequence, the global economy is weakening. Despite the better-than-expected performance of global activity in the first half of the year, forecasts now anticipate a loss in economic dynamism. This means that a generalized slowdown in demand and recessions in some of the major economies cannot yet be dismissed. While inflation has started to ease, thanks to a moderation in the pace of growth in commodity and energy prices, core inflation shows signs of persistence, anchored by the strength of the services sector and pent-up consumption financed by savings generated during the pandemic.

This circumstance foreshadows potential second-round effects via wage demands and, in turn, greater difficulty in making further progress toward controlling inflation. The likely outcome suggests that monetary tightening will inevitably extend into much of 2024. Moreover, this complex picture takes place amid latent risks — many of them with the capacity to suddenly affect economic activity and inflation — stemming from geopolitical tensions that, like the alter ego of the specter of Marxism, are casting a menacing shadow over the world. These risks take shape not only in the “normalization” of the war in Ukraine, but also in the strategic repositioning of major and middle powers, producing perhaps the most uncertain environment since the end of the Cold War.

Our mantra will be that the storm will pass; that the economy will return to sustained, low-inflation growth underpinning increased material wealth and, with it, higher levels of well-being. The unknown, however, lies in the tools that will make this come true. In his day, Keynes postulated that uncertainty is a crucial element for economic decisions. Expectations about the future play an essential role in the way individuals and companies make spending, investment, and employment decisions. When these expectations are obscured by uncertainty, they infect the “liquidity preference” with pessimism by reducing people’s spending, and they dampen the vitality of “animal spirits” by constraining entrepreneurial initiative. As an antidote to the toxicity of uncertainty, Keynes advocated stimulating aggregate demand through active fiscal and monetary policies — the former by boosting public spending and the latter by setting interest rates low enough not to exceed the parameter of the marginal efficiency of capital — and thus stimulate investment.

In contrast to this model is, among others, Robert Lucas’ rational expectations model, which posits that stimulus policies (fiscal or monetary) that are not sustainable in the long term will not have the effect of changing economic agents’ behavior in accordance with the intended results and, consequently, will not permanently affect the level of activity. Thus, any attempt to use such policies to reduce unemployment in the short term will end up being counterproductive, since, in response, economic agents will cancel out their effects through their behavior. In the long run, only more structural, credible economic policies that are perceived as capable of having lasting effects can positively modify rational expectations and allow the economy to achieve a new equilibrium in the long term.

Unfortunately, the current environment is an intellectual challenge for the two opposing models. On the one hand, the structural policies postulated by Lucas as a way to reach a new equilibrium in the long term are confronted with the immobility that is characteristic of the trajectory of liberal democracies. Notwithstanding the fact that populist movements have learned how to use the tools of democracy to seize power and thus limit the viability of economic policies in the long term, these policies are difficult to implement when governments (populist or not) are more concerned with the upcoming elections than with what may happen in the decades to come.

But Keynes would find it hard to sleep easy these days as well. Fiscal policy, the quintessential tool for stimulating aggregate demand, has run out of room to operate in most economies and is unlikely to induce dynamism in activity in the immediate future. The world’s public debt is practically equivalent to global GDP, and the OECD average now sits above 120%. The situation in emerging markets is no better, as governments in many of the major economies carry debt levels beyond their real capacity to sustain them.

In the end, on either side, all that remains is what appears to be the only weapon at hand to try to revive the world’s economic activity: monetary policy. Keynesians see this as a second-class item on the menu of tools for growth, while economists who prefer the rational expectations model consider it neutral in the long run. All in all, pragmatism forces us to accept that the most promising perspective at this time seems to be that of waiting for the monetary cycle to advance and fulfill its task: to raise interest rates to positive levels in real terms, contract consumption and investment, reduce the speed of price increases, reach a terminal rate, and, from that point on, begin the slow withdrawal of monetary restriction to start stimulating the economy again, thus fulfilling the old paradox of the poison becoming its own antidote.

Could it be that monetary policy possesses the elusive ability to change its shape in order to successfully tackle such diverse challenges? Or, on the contrary, is it inevitable that the economy will prolong its sluggishness, while the rest of the economic policy tools find the necessary space to become the levers to drive a new period of prosperity? It is difficult to foresee, and only the future will reveal it to us. Unfortunately, the economy, like Proteus, Poseidon’s old shepherd of seals, is by nature an elusive and changeable being, capable of transfiguring itself to avoid revealing the truth to those who seek it.