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Central bankers should prioritise growth over their pride

Policymakers risk overtightening in an effort to restore their inflation-battered credibility

January 24, 2023 / 06:27 PM IST
Children walk across a school crossing patrol 14 March 2005 in Glasgow, Scotland. (Photo by Christopher Furlong/Getty Images)

Children walk across a school crossing patrol 14 March 2005 in Glasgow, Scotland. (Photo by Christopher Furlong/Getty Images)

Stop. Look. Listen. Then proceed cautiously. That was the advice we were given as children for crossing the road, and it’s pertinent today for central bankers. After failing to stop consumer prices from accelerating, the risk now is that their pride is dented and they all overtighten to prove their inflation-fighting mettle — pushing us into a deeper recession. Having misread the the global economy for much of the past three years, they should consider pausing their rate increases to avoid compounding the felony.

Federal Reserve Chair Jerome Powell is frustrated that financial conditions are looser than he might wish for despite the fastest monetary tightening since the 1980s. If only bond yields would play ball by staying higher. Restoring inflation-fighting credibility, after an egregiously lax period, is uppermost in central bankers' minds. Their nightmare scenario is if inflation suddenly turns back up again, and the tight labour market drives them nuts. Better perhaps to overdo tightening to preserve credibility whatever the risks to growth, is the current thinking.

The pronounced drop in bond yields since the start of the year is at odds with what policymakers want to see, and is prompting tougher rhetoric on the need for ever-higher interest rates. “At this moment, the risk that we have to manage is the risk that we do too little, not too much,” was how Dutch central bank head Klaas Knot put it in an interview with Italian newspaper La Stampa this weekend. Something will have to give: Either bond markets are getting too far ahead of themselves, or central banks will be persuaded to stop hiking official borrowing costs. Several have already taken their foot off the rate-hike brakes, such as Norway and Australia.
The US yield curve has been inverted since July and the depth of the inversion has increased. That is about as reliable a long-term indicator of impending recession that we have. It's not infallible, but the signal gets louder if it is sustained, as it evidently is, with three-month Treasury bill yields 110 basis points higher than 10-year bond levels.

Recession Warning | The US bond yield curve has increasingly turned inverted since July