At a time of a raging war in Europe and increasingly hostile environments in east Asia and in the Middle East, it is understandable that the American and European monetary authorities are gun-shy to beat inflation at the cost of declining output, jobs and incomes.

Abandoning their ill-judged claims that accelerating inflation was a “temporary and reversible” phenomenon, the U.S. Federal Reserve (the Fed) and the European Central Bank (ECB) began raising interest rates last year, with the Fed starting the process in March 2022 and the ECB following that move in July 2022.

Last week, the upper limit of the Fed’s policy interest rate range was raised to 4.75%, while the ECB’s rate on its main refinancing operations reached 3%.

Both central banks clearly communicated that credit restraint measures must continue to bring inflation down to their medium-term targets of about 2%.

That was an important message to financial markets rallying on good corporate earnings and overly optimistic growth forecasts. Markets also seem to believe that monetary and fiscal policies will remain supportive of demand, output and employment.

All that looks like a good setup for a large asset repricing in the months ahead.

Dancing on a volcano

There are two reasons for that outcome: (a) the lagged impact of recent interest rate increases has yet to affect demand and employment, and (b) substantially higher interest rates are needed to bring down inflation and economic activity.

The market party continues because real interest rates – the key indicators of credit policy -- are still hugely negative. Correcting nominal policy interest rates by current consumer price inflation numbers, real interest rates are -1.75% in the U.S. and -5.5% in the Euro area.

Peer reviewed empirical research, published in scholarly journals, strongly suggests that real interest rates of about 2% are in the range of a broadly neutral monetary policy.

At current inflation levels, that means that nominal policy interest rates would have to be raised to 8.5% in the U.S. and 10.5% in the Euro area – just to bring the respective monetary policies to their neutral stance.

Those are frightening prospects for American and European credit conditions and for the medium-term growth outlook in the trans-Atlantic community. But that's what comes out of the hawkish statements of Fed and ECB leaders. They seem to have no doubt that much more monetary tightening has to be done to balance demand and supply forces in their labor and product markets.

That is reassuring because it shows that they are dismissing manipulations that the current levels of Fed and ECB policy interest rates are close to the extent of credit restraint necessary to stop and reverse the U.S. and euro area inflation pressures.

The toughest part is still ahead.  In addition to the difficult task of calibrating the range and the timing of future interest rate increases, the Fed and the ECB must also struggle with undisciplined fiscal policies, structural economic and social problems, domestic political tensions, European warfare and a gathering security crisis in east Asia.

Compete – smartly and peacefully – and win

For the U.S., tight labor markets, soaring wages and unit labor costs clearly show that a 3.4% unemployment rate is much too low -- even at a time when the domestic demand (gross domestic purchases) has collapsed to an annual rate of 0.6 in the fourth quarter of last year.

That is a structurally impaired labor market, where a historically low jobless rate continues despite 100 million Americans out of the labor force, 4.1 million surviving on part-time jobs and 5.3 million no longer looking for a job because they can’t find any.

In the middle of all that, American wages and unit labor costs are growing at respective annual rates of 4.5% and 6%. The economy, therefore, will have to weaken considerably to bring down labor costs and the general level of inflation.

It is also worrying that prices of American energy products and services are growing at rates of 14% to 41% -- while the U.S. still ranks as the world’s largest energy producer.

The euro area has relatively small wage claims but increasing prices of energy and unprocessed food accounted for 82% of its 8.5% inflation in January. The declining energy and food supplies are external shocks impervious to local credit conditions.

In addition to that, the ECB will have to accommodate huge fiscal handouts designed to support demand and employment by compensating large losses of purchasing power. The ECB also must prevent bankruptcies of its heavily indebted member countries.

The U.S. and the E.U. are in a no-win game. The trans-Atlantic allies should bury the hatchet with their systemic and strategic competitors to look after their severely stricken economies. Americans and Europeans have so many aces up their sleeves that they can easily win with a smart and peaceful competition in a rules-based free trade.