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MainStreet Macro: What happens when the best choice isn’t available? (Asking for a friend)

September 18, 2023 | read time icon 6 min

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They say a dog is a man’s best friend, so I guess this means my best friend is my dog, Lavender. But if I’m being honest, Lavender displays a clear preference for my husband over me. When he’s out of town, like he was last week, Lavender sees me as her best alternative.

The theory of the second best has a long history in economics. The basic idea is that it’s impossible to reach a goal’s optimal outcome without compromising the outcome of another goal. Settling for second-best means compromising on an ideal, but unachievable, alternative.

When inflation is high, the economy’s best friend is a really good central bank.

This month has been important for the world’s leading monetary policymakers, the European Central Bank and the Federal Reserve.

On Thursday, the ECB lived up to its role as the European economy’s best friend when its members voted to raise rates a quarter of a percentage point, the banks tenth rate increase. This week, Federal Reserve policymakers will meet to decide whether they want to, once again, move rates higher to help the economy.

When inflation soared during the pandemic, U.S. and European monetary policymakers made an unambiguous decision to aggressively raise rates. Now, as the two leading central banks approach their ideal level of inflation, their policy choices might diverge based on the realities and limitations of their regional economies. Here’s why.

Same target, different mandate

Both the ECB and Federal Reserve have strongly asserted their commitment to an ideal inflation rate of 2 percent.

But there’s a key difference. The Federal Reserve has a dual mandate: Price stability and full employment. That means the central bank, at times, has had to perform a balancing act to tame high inflation and high unemployment.

The ECB, on the other hand, has one job: To keep inflation at or near 2 percent.

Different inflation struggles

The opposing forces of supply chain disruptions and strong consumer demand pushed global inflation higher during the pandemic. European inflation, however, initially was propelled by the region’s dependence on Russian oil and the effects of war in Ukraine.

In the United States, inflation quickly transitioned from goods to services. The labor market was dramatically upended and was slow to recover. Labor shortages led to a sharp increase in wages.

Data released last week showed that U.S. inflation rose from 3.2 percent in July to 3.7 percent in August due to an upswing in oil prices.

Core inflation, a measure that omits volatile oil and food prices, was 4.3 percent in August, still far from the Fed’s 2 percent target.

The ECB has even further to go. There, core inflation has been relatively stuck all year, leveling out at 5.3 percent in August.

Both economies are benefitting from low unemployment, which is at a record low in the European Union and only 3.7 percent in the United States.

But if U.S. monetary policy intended to cool the economy eventually slows hiring and pushes the unemployment rate too high, the Fed will have to reconcile its competing policy priorities.

Growth outlook

Monetary policy is tricky. Raising rates too high or too fast runs the risk of slowing the economy too quickly and triggering recession. On this point, both Europe and the United States have good news to share about their fidelity to economic growth.

Defying the predictions of many economists, the United States and the 20 countries that use the euro expect economic growth in the fourth quarter of 2023.  According to the Federal Reserve Bank of Philadelphia’s quarterly Survey of Professional Forecasters, the United States is expected to grow at a little over 1.2 percent over the next three months, an upgrade from the no growth scenario that forecasters expected earlier this year.

In contrast, the ECB projects that its member countries will grow by less than 1 percent over the same period and downgraded its projection last week to flat (no growth) in the second half of the year.

The lower the growth outlook, the harder it is to achieve a 2 percent inflation target without wounding the economy in the process.

The ECB and the Fed both have some wiggle room, for now, to keep rates elevated. But if economic growth slows for one or both regions, their decisions on rates might become more complicated.

My Take

Over the past three years, central bank policy helped the global economy recover swiftly from a deep downturn and peak inflation.

Now the tradeoffs are getting more difficult. Soon, the ECB, the Fed, and other major central banks might face a fork in the road and choose to take divergent routes to support their individual economies.

A central bank might be an economy’s best friend when inflation clearly is too high. But when the bank’s policy decisions slow growth, the relationship might be more like the one Lavender has for me when compared to my husband: Good, sometimes even great, but still just second-best.