Central banks face economic overheating

Milton Friedman, Nobel laureate in economics in 1976, would emphasize that “Inflation is a monetary phenomenon.” This means that achieving and maintaining it at a low level, as well as reducing high inflation, must begin with monetary policies.

But what happens when monetary policy conflicts with political goals? Gerhard Schröder, former Chancellor of Germany from 1978 to 2005, would argue that any debate between politicians about monetary policy is counterproductive. Politicians in power pressure the Central Bank [CB] to lower the cost of money. This is because lowering the cost of money in the economy increases the demand for goods and services, helping economic growth to increase income and employment. Opposition politicians put public pressure on the CB not to lower the interest/cost of money before and during elections. They argue that lowering the cost of money makes it easier for majorities to win and penalizes the opposition.

Researchers of economic recessions argue that economic growth that does not come from real increases in the disposable income of individuals and businesses, but from a decrease in the cost of money, would not be healthy growth for the economy.

Trump, speaking a day after the Federal Reserve [FED], as widely expected by financial markets, kept its key lending rate unchanged, said that cutting interest rates would be “like jet fuel” for the economy, “but Jerome Powell doesn’t want to do that.” The Fed is currently in a critical situation in the US. The tariff war has increased inflation to around 2.6 percent from two percent, which is the Fed’s monetary policy target. This increase in inflation, mainly due to all the direct and indirect consequences of the tariff war, President Trump aims to mitigate by threatening the Fed chief to accelerate interest rate cuts and the size of the cuts should not be 0.25 as in the last case, not just the Fed’s from 4.5 to 4.25 percent.

The main reason why the FED and many central banks around the world are not rushing to reduce the cost of money in the economy even when the pressures are threatening to increase significantly (Powell) against the governors is simply due to the fact that in conditions where unemployment has reached the critical level of 4.2 percent, any reduction in the cost of money in the economy by increasing aggregate demand will increase the pace of economic growth and will naturally increase the demand for labor.

The demand for labor in the face of a labor supply limited to about five percent will lead to an increase in labor costs, which will increase the cost and prices of goods and services. This will have the negative effects of increasing inflation due to the spiral between increasing labor costs and increasing prices. Increasing labor costs overheat the engine of the economy. Figuratively speaking, when the engine of the car/economy overheats, the driver/Central Bank must take his foot off the gas so that the engine temperature drops and the car/economy does not burn out.

An overheated economy is one that is expanding at a rate that is unsustainable. The first indicator of an economy’s overheating compares the current level of economic output with estimates of potential output. If actual output is above potential output, this can cause overheating. High wage and price increases, large increases in credit, increases in imports to meet demand, and increases in borrowing can be both sources and warning signs of an overheating economy. This can lead to asset bubbles, particularly in housing markets, as has happened in Albania.

Asset bubbles make households feel richer. Euphoric financial investments, fueled by the cheap cost of money and excessive euphoria, sow the seeds of future financial crises. According to researchers, overheating occurs when the economy reaches the limits of its capacity to meet all the demand from individuals, firms, and the government. But overheating can result in a damaging recession. When the economy overheats, some producers are unable to supply all the goods that consumers demand. This can lead to faster price increases. Coping with and Controlling Economic Overheating is not easy.

Between June 2004 and June 2006, the Federal Reserve Board (FRB) raised interest rates 17 times as a gradual means of slowing America’s overheated economy. However, two years later, inflation in the US reached 5.6 percent. This rapid rise in prices was followed by a crippling recession, which saw inflation fall below zero within six months. Since World War II, the unemployment rate has generally fallen below five percent in the years immediately preceding recessions. This includes the years leading up to the Great Recession.

Symptoms of overheated economies include abnormally high levels of consumer confidence that fuel the risk of future recessions. Other causes of an overheated economy include asset bubbles and external economic shocks. An example of the latter are the oil shocks that occurred throughout much of the 1970s and 1980s. They resulted in recessions of varying duration and intensity, while America's oil import bill increased. The Burst of the Bubble dotcom in 2001 resulted in a recession. The 2008 financial crisis was the result of a real estate bubble. It had far-reaching implications, and resulted in a prolonged recession that was global in scope. The Great Recession of the late 2000s was preceded by an overheated economy. The unemployment rate fell steadily until 2007, peaking at 4.6 percent, below the normal rate of five percent.

Meanwhile, interest rates, which had been steadily rising, peaked at 5.25 percent in 2006, when Ben Bernanke became Federal Reserve Chairman and just before the crisis. Inflation also peaked at 4.3 percent at the same time. The Federal Reserve kept short-term borrowing costs in the range of 4.25 percent-4.50 percent. Fed Chairman Powell clarifies the Fed’s decision when he states: “Lowering interest rates usually stimulates the economy, but at a time when inflation is above target, doing so can also unleash an upward spiral of price pressures.” But while the transparency, accountability and efficiency of Central Banks’ monetary policies must be increased, but without threatening or undermining their decision-making independence.