The IMF Should Be Wrong About Rates, Central Bank Hawks Should Hope

There has been some repercussions from the April World Economic Outlook issued by the International Monetary Fund with regards to the long-term forecasts. IMF estimates that interest rates are expected to drop to zero as soon as the current bout of nasty global inflation subsides. If it is right about this big picture call, it will destroy the credibility of central bankers.

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Several economists have predicted that most economies will undergo anemic growth, which in turn will result in a reduction in prices. We will be back where we were in the last three years, with the gross domestic product floundering again, if this is indeed our fate. The last three years have been a roller coaster ride of angst and fear that ultimately landed us back where we were.

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It contrasts with the current aggressive policy stance adopted by policymakers, who argue that inflation must be beaten at any cost with ever-higher interest rates, while growth is left to take care of itself without ever-raising interest rates. It has been well-known for quite some time that far too much pandemic stimulus was applied from all angles and left in place for too long despite the many warnings made. It would be of great consequence if central banks were pushed into changing their rule so soon after tightening policy if they were forced to reverse course and slash rates so soon after enacting it, it would undermine their ability to carry out their mandated functions.

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Getting a correct estimate for short-term economic trends is often more challenging than making estimates for longer-term trends, so it is necessary to distinguish between short-term estimates. Although the IMF does allow for alternative scenarios, it does not necessarily agree with its conclusions, particularly regarding if public debt levels rise or fall. Some people disagree with the IMF's conclusions. As a result of rising government borrowing, former US Treasury Secretary Larry Summers predicts real interest rates will rise as high as 2%, twice as high as before the pandemic.

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To be honest, the IMF's central assumption is that mean reversion will take place to return the economy to its pre-global financial crisis state of affairs. Among the concepts in the report is a concept known as the natural interest rate, a concept whose goal is to ensure that official benchmark borrowing costs are neither too low to cause unwarranted inflation nor too high to suppress economic growth. In search of this holistic balancing point, armies of central bank economists are constantly searching, never knowing when they will succeed. The IMF has predicted a gradual decline in the natural interest rate over time, as greater depressive effects are expected to be felt by big growth economies such as India and China, resulting also in a lower natural interest rate in the future.

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Even though it is logical to believe that little has fundamentally changed since the global economy was suddenly shut down and then restarted, it's quite depressing to think that so little has changed. There are a number of factors that can influence natural interest rates over time, including a slowing productivity growth rate, an aging demographic, deglobalization, the switch to greener economies, as well as the amount of extra government debt required to facilitate that change. A majority of futures markets are anticipating that the Federal Reserve will be cutting interest rates before the year ends, which is quite different from the comments given by Fed officials about lowering interest rates.

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While central bankers are currently unable to justify that more aggressive action is still needed in light of slower inflation and weaker growth, they have to justify that more aggressive action is still necessary at this time. Despite the fact that central banks have tried their best to self-justify their actions by claiming they had no control over both the pandemic and the surge in energy prices; therefore, the failure of the central banks to anticipate the surge in price increases or curtail them is not a real fault of the central banks. Policymakers may be lured into another avoidable mistake if they raise rates before there is solid proof that the lag indicator of core inflation has started trending downward. A widespread and well-deserved opprobrium would result from a tightening and precipitating recession (or a credit crunch), which may undermine economic confidence in the long run. It is common for central banks to be mandated to control inflation as well as financial stability; this latter is equally important to the calming of consumer prices.

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While policymakers were skillfully able to avoid a ruinous downturn due to repeated lockdowns, they then fell asleep at the wheel amid runaway inflation after swift coordinated monetary and fiscal stimulus. In the event that central banks had not become so fixated on negative interest rates and quantitative easing for so long, a significant amount of that might have been avoided. Taking this into account, it could be prudent now to consider a pause, if only to observe the effects of tightening financial conditions over the past year at each meeting rather than just continuing the cycle.

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As Trade Algo reports, there is hope that the recent banking crisis is receding in the rearview mirror, as there is a growing hope that the end of the global rate-hike cycle is in sight. However, at the moment, the rhetoric is still overwhelmingly hawkish. In spite of this, if growth and inflation both collapse afterwards, it is going to be very difficult for our proudly independent monetary commanders to avoid the blamestorm that ensues.