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The writer is president of the Peterson Institute for International Economics.
After the European Central Bank and the Bank of Canada cut interest rates this week, attention has now turned to the US Federal Reserve and its stance on keeping rates “higher for longer.” But we should not lose sight of the broader picture of monetary policy. The more we look at how similar interest rate policies have been applied to very different economies, the more we should wonder about the similarity of the results.
Since the impact of Covid-19, followed by the Russian invasion of Ukraine, the Eurozone, the United States and, by the way, Canada, the United Kingdom, Brazil, Mexico and most other major currency areas (with the exception of Japan) have followed roughly the same path of inflation and interest rates. The Transitional Team can argue that these were global shocks and therefore this similarity was to be expected. But that is totally misleading. Yes, the shocks were global, but the common path that most have followed means that several other important economic factors do not seem to have mattered. This is surprising and important.
Consider the following differences between the eurozone and the United States. The United States exports food and energy, Europe imports them; The United States exports weapons and ammunition, Europe imports them; The United States is an ocean away from the war zone in Ukraine, the EU is absorbing millions of refugees and faces clear risk. Or take the pandemic. During that period, unemployment in the United States soared to more than 20 percent, while in the EU it barely rose, due to fundamental differences in labor markets and supporting policies. After initially adopting similar stances during Covid-19, the United States maintained a large fiscal expansion for much longer than Europe. Finally, the euro is not used as widely as the dollar in commercial, financial or reserve portfolios.
In the United States, the propensity of households to consume and borrow is much higher than in the eurozone. This has been evident in the rapid reduction of excess savings accumulated during the pandemic. Meanwhile, commercial and real estate lending in the United States has migrated from traditional banks to largely unregulated private lenders to a much greater extent than in Europe.
Variations in corporate concentration and antitrust policy between the two regions might be expected to produce divergences in their pricing behavior. And although unionization has recently strengthened in the United States, unions and collective bargaining still play a much larger role in setting European wages. But despite all this potential to divert nations from a common path, interest rate movements of similar size and pace by central banks on both sides of the Atlantic apparently had the same effect on inflation with approximately the same lags on both.
So do differences in labor market institutions, fiscal trajectories, or even labor productivity really not influence monetary transmission and the persistence of inflation? That’s what much of modern monetary theory tells us. In our 1998 book Inflation targetsBen Bernanke, Thomas Laubach, Frederic Mishkin and I said, in effect, that if an economy established an independent central bank with a transparent low-inflation target, that would anchor longer-term inflation expectations. This in turn would mean that monetary policy could respond flexibly to shocks in the short term, while inflation would still return to its target if policy remained consistent.
For the past four years, that has been the case. And this is true despite differences in national economic structures and the ways in which monetary policy makes its way into each system. A recent series of research papers by central banks, which have applied the model developed by Bernanke and Olivier Blanchard for the United States to their own economies, have produced similar results. Although the differences in the labor market turned out to be statistically significant, they were second order. Overinterpreting such small differences in inflation persistence would only result in counterproductive policy adjustment.
So what have the last few years taught us? We have learned that people in high-income democracies still very much dislike inflation, so this monetary regime appears to have considerable political legitimacy. There is a parallel here with the “end of history” argument made about liberal democracy after the fall of the Berlin Wall in 1989: there really are no credible alternative monetary regimes.
Independent central banks and low, transparent inflation targets are a deadly combination. That is why all large economies, with the exception of China, and the vast majority of high- and middle-income economies have adopted it. When the autocratic leaders of India and Turkey leaned on their central banks and lowered interest rates despite rising inflation, they paid an obvious price.
This does not mean that there will not still be inflationary shocks and fights over scarce resources, just as the supposed end of history in the political sphere did not end war and ethnic strife. The monetary story continues, more or less. But we should pay more attention to the similarities in central bank policy of late than the current debate makes it seem like.