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An enigma surrounds current monetary policy. Inflation has declined substantially in recent months, with core inflation dropping below 3% in the US (third quarter annualised rate) and, more recently, headline inflation falling to 2.9% in the Euro Area. This decline comes much earlier than can be explained by monetary policy. Although central banks have pursued a pace of monetary tightening unseen over the last four decades, monetary tightening takes close to two years to have a tangible impact on inflation.  

Some central bankers acknowledge this puzzle. Austan D. Goolsbee, president of the Federal Reserve Bank of Chicago, argues inflation fell much sooner than can be expected based on Fed policy moves: “Core inflation began moving down in 2023 – not mid-2024”.  In a similar vein, Isabel Schnabel, a member of the Executive Board of the ECB, recognises that “headline inflation in the euro area has declined notably” and that the “September print (of core inflation) was lower than expected”. To explain this, both central bankers point to the unwinding of previous negative supply shocks: falling energy prices and, more generally, considerable improvements in supply chains are working their way through the economy reducing both headline and core inflation.  

Core inflation coming down within close range of price stability targets is of course very good news, but it does raise an important question: If the main impact of past monetary tightening on inflation and the economy is still ahead of us, what will happen when its full effect reaches the economy?

A rough calculation based on research estimating the peak impact of monetary policy on inflation in the US, UK, Canada, and the Euro Area provides a tentative answer.  According to these studies, a 1 percentage point (pp) increase in interest rates would depress inflation in these four major economies on average by 0.4 pp. With interest rates having been raised by around 5 pp over the recent past, together with trillions of quantitative tightening probably having an additional impact equal to another 2pp of higher interest rates, 2.8pp of disinflation is still on its way.

Recent work from the Federal Reserve Bank of Chicago estimating the fall in core inflation in the US resulting from monetary policy actions to date and focussing on the interest rate channel only arrives at a similar number of  3pp, with most of the impact of monetary tightening still to come.

Monetary tightening could cost up to around 8% (!) of unrealised GDP

Looking at the impact on the real economy yields even more striking conclusions. The rough average derived from the research cited above is that increasing interest rates by 1pp would depress real economic activity by 1.1%. Monetary tightening could cost up to around 8% (!) of unrealised GDP.  

These estimates should not be taken literally but they do vividly illustrate a scenario that risks unfolding itself in coming quarters, a scenario whereby powerful disinflationary forces are unleashed on the economy at a moment when inflation is already largely contained. As a result, inflation would be pushed below the price stability target and this at the cost of an unnecessary economic downturn. We would go back to the situation of the past decade, with its “lowflation” and stagnation.  

From the start of this episode of monetary tightening, TUAC and economists such as Joseph Stiglitz,  have warned policymakers against the risk of central banks misreading the root cause of high inflation. Treating inflation as originating from the excess demand side, while the problem is on the supply side, is a recipe for monetary overtightening and unnecessarily damaging the economy.  Given time, markets are strong enough to deal with supply-side disruptions: problems in global supply chains get repaired, more energy and commodity supply is put online while workers, also thanks to high relative wage increases, move into those sectors to which demand has shifted. Resorting to monetary tightening with its long time lag to address supply-side disruption is not the right answer as disinflationary forces are set in motion precisely at the moment inflation is already back down.    

Looking to the future, the OECD has an important role to play.  Climate change as well as geopolitical events are expected to inject more volatility into the supply side of the global economy. Sticking to a traditional approach of monetary policy for fighting any kind of inflation by squeezing the economy risks making the same mistakes over and over again. The OECD, being THE think tank of advanced economy governments, is in a pole position to launch an in-depth reflection on innovating monetary policy frameworks to ensure better policies for future supply-side-related inflationary shocks. It should not miss this opportunity.