Peak inflation? The new dilemma for central banks

The world’s leading central banks talked tough this week, but carried a smaller stick.

After a series of meetings on Wednesday and Thursday, the Federal Reserve, European Central Bank and Bank of England all chose to shift their inflation-fighting strategy from a recent pattern of interest rate rises of 0.75 percentage points down to a half point. Switzerland, Norway, Mexico and the Philippines also slowed the pace of interest rate rises.

They married weaker action, however, with stronger words. The Fed talked of having “more work to do” to defeat high inflation, the ECB spoke of “more ground to cover” while the BoE insisted it needed to be “forceful” in battling price rises.

These moves were far from co-ordinated. Instead, the world’s central banks are trying to buy themselves the space to raise rates further if they feel it necessary at a time when the apparent peaking of inflation in many countries could make that more politically more complicated.

Seth Carpenter, who spent 15 years at the Fed and is now the global chief economist at Morgan Stanley, says that most central banks are getting near their peak policy rates, one that is likely to cause a sharp slowdown or recession in their economies. As a result, he said it was a wise strategic move to suggest more action now.

“For central bankers, they really do have the responsibility of macroeconomic stability,” he says. “So I think they would rather be wrong by talking tough and saying that they’re ready to keep raising rates more and then happily find out later that they didn’t have to do more, rather than telling the world that they’re done and then go, ‘Oops, we have to do more.’”

Hawkish forecasts

The Fed moved first on Wednesday, breaking a series of four 0.75 percentage point rate rises and implementing a half-point increase so that interest rates now sit in a target range between 4.25 per cent and 4.5 per cent.

The unanimous decision to slow the rate of increases was accompanied by hawkish forecasts and rhetoric. A fresh set of economic projections signalled officials’ intent to raise the policy rate just above 5 per cent next year, with no rate cuts until 2024. Fed chair Jay Powell sought to extinguish any lingering scepticism about the US central bank’s plans to stamp out “unacceptably high” inflation.

“We have covered a lot of ground, and the full effects of our rapid tightening so far are yet to be felt,” he told reporters. “Even so, we have more work to do.”

In Frankfurt, interest rates at 2 per cent are still considerably lower than in the US but Christine Lagarde, the ECB president, insisted the smaller rate rise than in previous meetings was not a shift towards ending the rate-tightening cycle that it appeared.

“The ECB is not pivoting,” she said, adding that the eurozone’s central bank had “more ground to cover, we have longer to go”, than the Fed. Her near promise of further half-percentage point rate rises coming in February and March surprised economists, many of whom had expected the central bank to quickly end its cycle of rate rises in the next few months.

Ukrainian firefighters work to extinguish a fire at the scene of a Russian shelling in the town of Vyshgorod, north of Kyiv
Firefighters in the town of Vyshgorod, north of Kyiv, extinguish a fire at the scene of a Russian shelling. Inflation and growth in almost all countries depend on the progress of the war in Ukraine © Efrem Lukatsky/AP

In the UK, where the authorities are enjoying a lower international profile now than during September’s disastrous mini Budget, the Bank of England raised interest rates for the ninth consecutive meeting to 3.5 per cent, the highest in 14 years. BoE governor Andrew Bailey insisted the move had been prompted by further evidence of inflation becoming ingrained into private sector wage increases. This, he said, “justifie[d] a further forceful monetary policy response”.

Although the initial causes of high inflation have been different in the eurozone, UK and the US, economists pointed out that all three central banks face the same difficult communications challenge for 2023.

Headline inflation has almost certainly peaked and will fall next year, but officials are far from certain that the underlying inflationary pressures will also disappear. Their worry is that inflation will take too long to fall back to their hoped-for 2 per cent targets and might stick at a rate considerably higher.

Some of the concerns about future inflation in Europe relate to the time it will take for the 2022 energy shock to work its way fully through the economy.

All three central banks worry that domestic service sector prices might continue to rise strongly in still tight labour markets where wages are rising at rates that are higher than they believe are compatible with the 2 per cent target for inflation.

With this difficult challenge for next year, financial markets struggled over the past few days to interpret the interest rate decisions and communications coming from central bankers.

They found the ECB’s message easiest to interpret. Lagarde’s words were much more aggressive than they had expected and “drove the biggest market reaction”, according to Philip Shaw of Investec, the investment firm. The benchmark S&P 500 index fell 2.5 per cent on Thursday on the back of hawkish noises coming out of the ECB.

Krishna Guha, head of policy and central bank strategy at US brokerage Evercore-ISI, says: “I take Lagarde at her word when she says the ECB is going to keep hiking aggressively.” Like many analysts, Guha raised his forecast for the likely peak in the ECB’s deposit rate from 2.75 per cent to 3.5 per cent after Lagarde’s comments on Thursday.

In contrast, many investors across Wall Street either question the Fed’s resolve to keep raising rates or bet the US central bank will flinch at the first sign of real economic distress. Despite Powell’s protestations on Wednesday, traders in federal funds futures markets firmed their bets that the policy rate would peak below 5 per cent next year and that the central bank would slash rates by next December.

“The market is not buying it,” says Tiffany Wilding, North American economist at Pimco, the bond fund manager.

Complicating the Fed’s messaging is the fact that Powell on Wednesday did not explicitly rule out the Fed again lowering the size rate rises at its next policy meeting and implementing a quarter-point increase. UK markets also interpreted the BoE’s action as mildly dovish and moderately scaled back their expectations of future rate rises.

The most important question hanging over these diverse market reactions is what the underlying strategy of central banks is likely to be in 2023 as headline inflation falls.

Many economists believe that policymakers want to act aggressively before inflation falls sufficiently and economic conditions become too difficult to make further rate rises almost impossible to explain.

Dario Perkins, global macroeconomist at TS Lombard, a consultancy, says that tough talk on monetary policy is part of the game central bankers are playing to inject caution into wage bargaining and corporate price setting, saying that they “have an incentive to play up recession risks” because it is helpful in moderating inflationary pressure.

But a large body of economists also worry that the hawkish noises coming out of central banks are real and that policymakers will go too far, generating a deeper recession than officials want or think necessary to tame price rises.

Many ECB-watchers believe, for example, that the Frankfurt-based institution was too pessimistic on inflation and too optimistic on growth in its latest forecasts this week, leaving it at risk of raising interest rates too far.

Carsten Brzeski, head of macro research at Dutch bank ING, says the ECB could be forced to scale back its plans for raising rates aggressively once it realises “its forecasts for the eurozone economy are too optimistic”.

Tom Porcelli, chief US economist at investment bank RBC Capital Markets, has a similar view about the Fed. “The reversal is going to happen quicker than some people still seem to appreciate, and I think this is going to be true for probably most central banks around the world,” he says. “You have the big economies that are all either on the verge of, getting close to, or already in recession. You don’t need to be a great tea-leaf reader to see what is coming in the not-too-distant future.”

Covid-19 tests are administered in a street booth in Shanghai
Covid-19 tests are administered in a street booth in Shanghai. The success of China’s move away from a zero-Covid policy and its impact on inflation will be watched closely by central banks © Alex Plaveski/EPA-EFE/Shutterstock

These divergent views between those saying central bankers are showing appropriate concern about lingering inflation risks versus those who believe the tough messages are real and excessive show how difficult it is to gauge the economic outlook for 2023.

Both inflation and growth in almost all countries depend on the progress of the war in Ukraine, which will affect energy prices, the success of China’s move away from a zero-Covid policy, the uncertain effects of the interest rate rises already implemented and the risk that households and companies tighten their belts as a downturn arrives, making it substantially worse.

The BoE is already happily using the word recession to describe the UK outlook, warning the current downturn could be prolonged. While the ECB talks of the possibility of a “short and shallow” recession only lasting for the next couple of quarters, Powell at the Fed says it is unknowable whether the US will slip into recession. A soft landing is still a possibility for the US economy.

Central banks have not had to defeat a serious bout of inflation in 40 years, and few are confident they know whether officials have done too little, enough or too much with interest rates to date to ensure they can bring back price stability to advanced economies.

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