Central banks are being put to the test by the recent resurgence in inflation, with the US recently reporting an annual rate of 6.8% inflation, the highest in almost 40 years. The question everyone is asking is whether this inflation is temporary (“transitory”) or persistent.
If it is only temporary, it would be counterproductive to treat it aggressively. If central banks tighten monetary policy unnecessarily by sharply raising short-term interest rates or quickly undoing government asset purchases (known as quantitative easing, or QE) that supported many economies during the Covid economic shock, it will unnecessarily delay growth. Recovery.
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Public statements by central bankers point to the tough decisions that lie ahead. The Chairman of the US Federal Reserve, Jay Powell noted Recently, the fact that the strong US economy combined with rising inflation meant that the Fed would “cut back” its QE asset purchases more quickly (currently due to end in June 2022).
The Bank of England is due to end its asset purchases this month, and Huw Pill, the chief economist, has indicated that “The conditions already existed for him to vote for higher interest rates.” The Director of the European Central Bank, Christine Lagarde, has hit a more dovish note, saying the ECB is unlikely to raise interest rates in 2022, despite inflation well above its 2% target as it sees it as transitory. It is not clear if the ECB will expand its QE program beyond March 2022.
So how important is the current inflationary shock and what are its causes?
Causes of inflation
As you can see below, the recent price increases are not large compared to those of the 1970s and early 1980s, which were caused by large increases in oil prices.
Consumer price inflation in some economies, 1970-2021
However, when the current rise in inflation is compared to that of the 2000s, this is one of the biggest shocks since the Bank of England became independent and the ECB was created.
Consumer price inflation in the UK, US and eurozone, 2000-21
The current inflation is mainly due to the disruption that the pandemic has caused in the main global supply chains. In sectors such as electronic products and vehicle production, bottlenecks and shortages of key inputs like semiconductors emerged as consumer demand rebounded more quickly after the first wave of pandemics than suppliers were able to keep up. Similary, the shortage of shipping containers and cargo capacity have increased costs.
The rapid economic recovery in 2021 has also put pressure on energy prices, especially gas spot prices in Europe. Meanwhile, there have been labor shortages to deal with: the UK and the US are among those nations that seem to be watching labor force participation falling because people retire. The UK and some northern European economies also haven’t seen enough short-term migrants they need for sectors like hospitality and freight. When fewer workers are available, employers must pay higher wages to fill positions.
How should monetary policy respond? For central banks, the key question relates to inflation expectations. If consumers and businesses believe that inflation will continue at equally high levels, as they did in the 1970s, they will try to incorporate it into future wage claims and pricing. Then inflation will become more persistent.
What is the evidence for these “second round effects” on wages and pricing? There is some evidence from consumer surveys and bond prices that inflation expectations in the US, eurozone and UK have marginally increased in the second half of 2021, but they still seem contained.
A difference with the 1970 and 1980 is that labor markets are more flexible, in the sense that unions have less wage bargaining power in the private sector, and there is greater international competition as a result of globalization. Rather than triggering a spiral of prices and wages, the rise in prices could be absorbed by falling wages in real terms (which means that they would rise below the rate of inflation).
That depends on Covid supply disruptions being temporary, as ultimately, with labor markets tightening in most countries, employers would eventually have to pay wages that keep up with inflation. Unfortunately, the omicron variant is a sign that as Covid becomes endemic, the economic recovery could be interrupted by occasional disruptions and more supply shocks, potentially increasing pressure on employers to pay higher wages.
Central banks and independence
The key to measuring whether inflation remains transitory will be the future job market and expectations data. Suppose that by early to mid-2022, inflation appears to be dissipating, central banks might only need to increase rates gradually to anchor expectations.
But if the data points to inflation stubbornly staying above central bank inflation targets (say 4% -5%) over a longer time horizon, it would be evidence that a price spiral has been established. and wages. There is no alternative but to substantially increase short-term interest rates and reduce QE, which could reduce economic activity until wage and price increases moderate. As we have known since the 1970s and early 1980s, this can cause painful recessions that lead to unemployment.
In any case, the QE must be finished with care. It has created additional demand for government bonds and increased the supply of money available to invest in other assets, such as stocks, so the reduction has the potential to cause volatility in these markets. This is likely to be compounded by investors selling stocks in the belief that tighter monetary conditions will mean lower economic growth.
QE purchases have also greatly expanded central bank balance sheets. For example, the Fed’s balance sheet has increased from around $ 4 trillion (£ 3 trillion) to $ 8.7 trillion since the start of the pandemic. In addition to tapering, this will have to unwind. It can be done very slowly as the QE debt matures or, if central banks feel they need to tighten monetary policy more aggressively, by selling these bonds on the market. This could mean selling at a loss, then governments would have to rebuild central bank balance sheets. By making central banks dependent on governments in this way, you could compromise their independence.
There is also a more immediate challenge to central bank independence, which was issued several decades ago to prevent monetary policy from being subject to political interference and to assure markets that inflation will be kept under control. Still just because A central bank sets rates independently of the government, it may not be immune to external pressures during a major economic crisis. Central bankers could succumb to political and media pressure to act too quickly to combat inflation or too slow to preserve economic recovery.
Some central banks like the Bank of England. seems set up for Keep the fire on interest rates until early 2022, despite Huw Pill’s comments, given the uncertainties surrounding the omicron variant. The ECB is equally stable. So all eyes will be on the Fed on Wednesday the 15th to see if it will cut QE faster than previously announced. For the moment, I’d say it would be better to wait. The next few weeks will give us more data on both inflation expectations, but also on how Covid could continue to affect our economies.