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

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

Central banks are getting twitchy about inflation. Cost of living pressures are rising just about everywhere and the relaxed mood of last autumn has been replaced by an urgency that could soon become panic.

In the US, where inflation is at its highest in four decades, the latest chatter on Wall Street is that the Federal Reserve will take every opportunity to raise interest rates between now and the end of the year, seven times in all.

Inflation figures for the UK are out on Wednesday, and even though little change is expected this month from the 5.4% recorded in December, further increases are expected by the spring. Bank of England forecasts should be taken with a pinch of salt because they have been wrong for the past year, but for what it’s worth Threadneedle Street now predicts inflation to peak at just over 7%.

The Bank of England and the Fed are getting stick for waiting so long before taking steps to rein in inflation. The US and the UK economies, it is said, are overheating as the threat from the pandemic recedes, one reason being that central banks have delayed putting up borrowing costs.

This might seem a compelling argument but the idea that the US, the UK and the big economies of the eurozone are in the middle of a rampant boom doesn’t square with the facts. The fastest growing G7 economy over the past two years has been the US, where output has increased by 1.5% on average. The next best-performing country has been France, where growth has averaged less than 0.5% a year. UK output is 0.4% below its pre-pandemic level, while Germany and Italy have still more ground to make up.

So where is the inflation coming from? The answer is that prices are rising more quickly than they were because of supply-side pressures. As economies lifted restrictions and demand has returned to more normal – although not boom – conditions, severe bottlenecks have emerged. Everything from computer chips to natural gas has been in short supply, and that has pushed up inflation.

This was the explanation the Fed and the Bank of England trotted out last summer and autumn when price pressures first started to bite, and it was broadly right. Yes, they said, interest rates would need to be raised from their emergency levels but there was no great urgency because their economies were still operating short of where they would have been in the absence of Covid-19. In any event, increasing the cost of borrowing would have zero impact on global energy prices.

The Bank of England had an additional problem, which was that Rishi Sunak removed some of the support the Treasury was providing for the economy last autumn. With the benefit of hindsight, the end of the furlough did not lead to the feared rise in unemployment, but there was no way of knowing that at the time. As a result, the Bank’s monetary policy committee responded to the chancellor’s tightening of policy by keeping interest rates lower than they might otherwise have been. As the National Institute for Economic and Social Research pointed out last week, it would have been preferable had policy been the other way round, with a less aggressive approach by Sunak providing space for the Bank to raise rates modestly.

The Bank of England and the Fed subsequently realised price pressures were more acute than they had predicted, while unemployment fell more quickly. This raised concerns that workers would use the bargaining power provided by a tight labour market to secure higher pay awards. If, say, an annual inflation rate of 7.5% in the US led to salary increases of 8%, a wage-price spiral redolent of the 1970s would then set in.

In the short-term, inflationary pressures are likely to persist. The first three months of 2022 will be an echo of last summer as restrictions are lifted and economies open up. Those people who have built up savings during lockdown now have cash to spare to buy a new car or book a foreign holiday. Firms will have trouble filling vacancies, while energy costs will remain high as long as there is a threat of Ukraine being invaded. The cost of a barrel of oil is already closing in on $100.

Things look a lot trickier from the spring onwards. In the UK, energy bills and taxes both go up in April, and it will become clear to many workers that their wages are not keeping up with inflation. Cost increases that were initially inflationary will turn deflationary as they add to costs for business and squeeze consumer spending power.

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Against this backdrop, the Bank of England needs to calibrate its response carefully (as does the Fed). Central banks clearly feel their credibility will be at risk if they allow inflation to take hold, and that means a more aggressive approach to interest rates than seemed likely as recently as late last year.

There is a way that central banks can emerge with their credibility intact. If they are right in believing inflation is currently a supply-side problem, only a limited tightening of policy will be needed. Inflation will come down with only a small increase 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 is what will happen if they add to the pain already coming the way of their economies through interest-rate overkill. The growing risk of that would quickly turn the recovery of early 2022 into the recession of early 2023.

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