Central bankers have lost sight of their North Star

When Christopher Columbus lost sight of the Portuguese mainland in October 1492, he relied on the stars, more precisely the North Star, to keep the right course on his way to the New World. The astronauts who landed on the moon more than 400 years later also relied on the stars they saw for navigation. Like them, the monetary explorers at the central banks also use stars to set their course.

The North Star of the central banks is called r*, which stands for the neutral real interest rate. That is the level of the official interest rate at which the economy is growing nicely without overheating, just about everyone who wants to work is also working and inflation is low and stable. In other words, the neutral real interest rate is the level at which monetary policy neither stimulates nor slows down the economy. In other words, it is a yardstick to determine whether a central bank is stimulating or not. If the real interest rate of a central bank, such as the Fed in the US or the ECB in the eurozone, is below r*, the economy will get a boost. If the interest rate is higher than r*, the central bank provides wind from the front.

High inflation back in the loft
That r* can't be read off a Bloomberg screen or anywhere for that matter. Economists can only estimate them. The most recent estimates are that the r* is 0,6% for the US and 0,3% for the eurozone. Tonight (Wednesday, March 16), the Fed's Interest Rate Committee will announce how much the bank will raise its official interest rate. And how often the main interest rate will be raised this year. Analysts expect a 0,25 percentage point move, followed by another three or four rate hikes later this year. All this with the aim of getting the far too high inflation back in the loft and keeping it there.

With the r* we have the benchmark to answer whether this will be successful with the aforementioned interest rate hikes. If the Fed raises interest rates four times this year by 0,25 percentage points and once by 0,50 percentage points, the official interest rate in the US will be between 1,5 and 1,75%. Inflation in the US is now 7,9%. If we assume that monetary depreciation will decrease later this year and inflation will be 2022% over 4 as a whole, then the official interest rate of the US central bank will be around -2,25% at the end of this year. That is much lower than r* of 0,6%.

Do not confuse decisive action
In the eurozone, the ECB expects inflation to be 2022% over 5,1 as a whole. The official interest rate of the bank is 0% and if all goes well, the bank will raise that interest by 0,25 percentage point at the end of this year. The real ECB interest rate will therefore be about -4,8%, rather lower than the r* of 0,3%. The conclusion: do not confuse interest rate hikes by the Fed – and certainly those of the ECB – with decisive action against inflation, let alone a crusade against it. In other words, I personally expect inflation to be higher rather than lower in the coming years than many, including the central banks, are now counting on. With all its consequences.

Edin Mujagic

Edin Mujagić is an economist and manager at Beleggingsfonds Hoofbosch. He focuses on global central banks, and in his blogs he writes mainly about developments in interest rates and inflation. He has also written several books.

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