Central banks should be cautious in calibrating a response to inflation | Larry Eliot


CCentral banks are getting nervous about inflation. Pressure on the cost of living is mounting almost everywhere, and last autumn’s relaxed mood has given way to an urgency that could soon turn to panic.

In the US, where inflation is at four-decade highs, Wall Street is saying the Federal Reserve will take every opportunity to raise interest rates a total of seven times by the end of the year.

Inflation figures for the UK are due on Wednesday and although little change is expected this month from the 5.4% recorded in December, further increases are expected into spring. The Bank of England forecasts need to be taken with a pinch of salt as they were wrong last year but for what it’s worth Threadneedle Street is now forecasting inflation to be just over 7%.

The Bank of England and the Fed are adamant that they have waited so long before taking steps to curb inflation. The US and UK economies are said to be overheating as the threat of the pandemic wanes, in part because central banks have delayed raising borrowing costs.

This may be a compelling argument, but the notion that the US, UK and the major eurozone economies are in the midst of unbridled booms is not factual. The fastest growing G7 economy over the past two years has been the US, where output has grown by an average of 1.5%. The second best country was France, where growth averaged less than 0.5% per year. UK production is 0.4% below pre-pandemic levels, while Germany and Italy have yet to gain ground.

So where does inflation come from? The answer is that prices are rising faster than before due to supply-side pressures. Serious shortages have emerged as economies lift restrictions and demand has returned to more normal – if not booming – conditions. Everything from computer chips to natural gas was in short supply, and that drove up inflation.

That was the statement made by the Fed and Bank of England last summer and autumn when price pressures first took hold, and it was broadly correct. Yes, they said, interest rates need to be raised from their emergency levels, but there is no great urgency because their economies are still operating below where they would have been without Covid-19. In any case, an increase in borrowing costs would have no impact on global energy prices.

The Bank of England had an additional problem when Rishi Sunak withdrew some of the support the Treasury gave to the economy last autumn. In hindsight, the end of vacation didn’t lead to the feared rise in unemployment, but that wasn’t foreseeable at the time. As a result, the Bank’s Monetary Policy Committee responded to the Chancellor’s monetary tightening by keeping interest rates lower than they otherwise would have been. As the National Institute for Economic and Social Research pointed out last week, it would have been preferable if the policy had been reversed and a less aggressive approach by Sunak had given the bank room for modest rate hikes.

The Bank of England and the Fed then found that price pressures were stronger than predicted while unemployment fell at a faster rate. This raised concerns that workers would use the bargaining power of a tight labor market to obtain higher wages. For example, if an annual inflation rate of 7.5% in the US resulted in wage increases of 8%, a wage-price spiral reminiscent of the 1970s would begin.

In the short term, inflationary pressures are likely to persist. The first three months of 2022 will echo last summer as restrictions are lifted and economies open up. Those who built up savings during lockdown now have money left over to buy a new car or book a holiday abroad. Businesses will struggle to fill vacancies, while energy costs will remain high as long as there is a threat of an invasion of Ukraine. The cost of a barrel of oil is already approaching $100.

From spring it looks much trickier. With energy bills and taxes soaring in the UK in April, many workers will find their wages are not keeping pace with inflation. Cost increases that were initially inflationary become deflationary as they raise costs for businesses and depress consumers’ spending power.

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With this in mind, the Bank of England needs to carefully calibrate its response (as does the Fed). Central banks clearly believe their credibility will be threatened if they allow inflation to prevail, and that means a more aggressive approach to interest rates than was thought likely late last year.

There is a way central banks can emerge with their credibility intact. If they are correct in believing that inflation is currently a supply-side problem, only limited policy tightening is required. Inflation will fall with only a modest rise in unemployment. The bank and the Fed will then be the heroes of the hour.

There is, of course, an alternative scenario in which central banks act tough but still damage their credibility, which will happen if they add to the pain already being inflicted on their economies by excessive interest rates. The growing risk of this would quickly turn the early 2022 recovery into the early 2023 recession.


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