News Reading/ Economic policymaking -A heavy blow, cushioned

Inflation is almost vanquished and a recession looks unlikely. What went right?

Not Long ago central bankers everywhere were jacking up interest rates. No longer. In June the European Central Bank reduced rates for the first time since before the covid-19 pandemic. In July policymakers at the Bank of England voted to cut rates. Other central banks, ranging from those in Canada and Chile to Denmark, are also in on the action. Before long America will follow. On August 23rd Jerome Powell, chair of the Federal Reserve, noted that "the time has come for policy to adjust". And as central bankers loosen policy, they are daring to dream, for a "soft landing" is within reach.

The aeronautical metaphor has two components: bringing down inflation to \(2 \%\), and avoiding a recession. Many economists had once believed that this would prove impossible. History showed that when central banks raised interest rates quickly, economic misery soon followed as people struggled to repay their debts and it became too expensive for companies to borrow in order to invest. The biggest ever co-ordinated global monetary tightening, which began in the late 1970s, provoked a big downturn in the early 1980 s. From late 2021 to early 2024 the rich world's average policy rate rose by five percentage pointsnot by quite as much as in the late 1970s, but still one of the fastest increases on record (see chart 1 on next page).

Higher borrowing costs have helped contain inflation. In the median OECD country consumer-price growth peaked at \(9.5 \%\) year on year in mid-2022. By the second quarter of this year, inflation was just \(2.7 \%\), and it has continued falling since then. Price rises in many rich countries are now practically at target, or even below. Inflation in Italy was just 1.6% in July; Canadian inflation was \(2.5 \%\) in the same month. There is little sign that prices are going to accelerate again, meaning central bankers feel comfortable loosening the monetary strings. Across the G10 group of countries, nominal wages are growing by \(4 \%\) year on year, a bit higher than before the pandemic (see chart 2). That is still too elevated for on-target inflation but wage growth is falling and is likely to continue to do so.

As inflation has declined, the rate of economic growth has remained surprisingly steady. In the second quarter of this year the combined real GDP of the OECD grew by \(1.8 \%\) year on year, the fastest since the end of lockdowns. True, about half the countries in the club, including Britain, New Zealand and Sweden, have at some point in the past two years seen their GDP fall for two consecutive quarters. So did America in early 2022. Although consecutive falls in national income represent one definition of recession, as any economist will tell you, a proper recession is like pornography: you know it when you see it. People lose their jobs by the million, corporate earnings plummet and firms close. None of this has happened.

Unemployment in the OECD remains around \(5 \%\). It has edged up from earlier in the year, but this is hardly a reason to panic. Job growth across the rich world remains reasonably strong. In many countries, including Britain, France and Germany, the number of unfilled vacancies is still higher than its pre-pandemic norm, suggesting that demand for labour remains high. This has brought in people who had once been on the economic sidelines by encouraging them to look for work. The OECD's working-age labour-force-participation rate is at an all-time high. In the short run, at least, an influx of job-seekers can raise the unemployment rate.

Businesses, meanwhile, are doing fine. In a normal recession company profits plunge: customers vanish and firms have to offer steep discounts. In the second quarter of 2024, though, global corporate earnings grew by more than \(10 \%\) year on year, according to Deutsche Bank-their biggest rise in two years. Although business confidence across the OECD remains depressed, it is at least higher than it was last year. Nervous nellies point to a rise in company bankruptcies since 2020-21. But this trend reflects a return to normality from the strikingly low rate of failure during the pandemic, when a plethora of government programmes made it practically impossible for a business to go under. In absolute terms, bankruptcies remain low.

How has the rich world done it? One possibility is that modern economies are less sensitive to interest-rate changes, owing to a decline in capital-intensive industries such as housebuilding and manufacturing, which require businesses to borrow large sums in order to invest. Borrowers are behaving differently, too. In the low-interest-rate years, mortgage-holders in the rich world loaded up on fixed-rate products, shielding themselves from today's higher rates. This has left them in an odd position where higher rates are actually good for their pocketbooks, since they benefit from better returns on their savings and do not have to pay more to service their debts. We estimate that across the European Union, higher interest rates have raised households' earnings from their savings accounts by \(40 \%\) more than the increase in their debt repayments-and find similar results for rich countries elsewhere.

Fiscal policy is also playing a role. In 2020-21 rich-world governments handed out vast amounts of stimulus. Huge savings that were accumulated by businesses and households during these years have since cushioned the blow of higher rates. Politicians have also continued the fiscal largesse. This year rich-world governments will run a deficit of \(4.4 \%\) of GDP. America is running a deficit of \(7 \%\) of GDP, which represents bizarre economic management at a time of such low unemployment. The approach has, though, helped channel money towards the real economy, even as central banks tighten financial conditions.

Perhaps the business cycle is now on the cusp of turning. Mr Powell hinted that worries about a weakening economy had motivated his decision to signal rate cuts,noting he and his colleagues at the Fed "do not seek or welcome further cooling in labour-market conditions". Yet there is little indication that the economy is about to hit turbulence. Credit-card spending remains strong. A high-frequency measure of economic activity across rich countries, produced by Goldman Sachs, a bank, is remarkably steady (see chart 3). A widely watched measure produced by the Atlanta Fed suggests that America's GDP is growing at an annualised rate of \(2 \%\).

Even if their judgment on the state of the economy proves incorrect, central bankers could still be right to want to cut rates. Borrowing costs at their current level may be unnecessarily high, pressing down too much on economic activity and inflation. Policymakers may have to increase the pace of cuts if evidence emerges of a genuine economic slowdown. It is still too early to celebrate a soft landing, especially with fiscal policy still so generous. But the runway is now clearly in view.