The central banks of the major economies expected only a few months ago to tighten their monetary policy very gradually. Inflation appeared to be fueled by an unusual mix of supply shocks associated with the pandemic and later Russia’s invasion of Ukraine, and was expected to decline rapidly once these pressures appeased.
Now, with inflation at multi-decade highs and price pressures spilling over into housing and other services, central banks recognize the need for more urgent action to avert a drop in inflation expectations and damage their credibility. Policy makers must heed the lessons of the past and be determined to avoid potentially more painful and disruptive adjustments later.
The Federal Reserve (Fed), Bank of Canada and Bank of England have already hiked interest rates significantly and signaled that they expect to pursue larger hikes this year. The European Central Bank recently raised rates for the first time in more than a decade.
Higher real rates to help lower inflation
Central bank actions and communications on the likely policy path have led to a significant rise in real (i.e. inflation-adjusted) interest rates on government debt since the start of the crisis. year.
While short-term real rates are still negative, the U.S. real rate forward curve—that is, the path of one-year real interest rates on the one- to ten years implied by market prices — rose across the curve to a range between 0.5% and 1%.
This trajectory is roughly compatible with a “neutral” real policy that allows production to develop around its potential rate. The Fed’s summary of economic projections in mid-June suggested a real neutral rate of around 0.5%, and policymakers saw output expansion of 1.7% this year and next, which which is very close to the estimates of the potential.
The forward curve for real rates in the euro zone, represented by the German bunds, also moved up, although it remains deeply negative. This is consistent with the fact that real rates are only gradually converging towards neutrality.
Rising real interest rates on government bonds have driven even higher borrowing costs for consumers and businesses and contributed to a sharp drop in equity prices globally. The modal view of central banks and markets seems to be that this tightening of financial conditions will be enough to bring inflation back to target levels fairly quickly.
For example, market-based measures of inflation expectations point to a return to inflation of around 2% within two to three years, both in the United States and in Germany. Central bank forecasts, such as the Fed’s latest quarterly projections, point to a similar moderation in the rate of price increases, as do surveys of economists and investors.
This seems like a reasonable baseline for several reasons:
- Ongoing monetary and fiscal tightening is expected to dampen demand for energy and non-energy goods, particularly in interest-rate sensitive categories such as consumer durables. This should lead to a slower rise or even decline in commodity prices, and could also lower energy prices in the absence of further disruptions in commodity markets.
- Supply-side pressures are expected to ease as the pandemic loosens its grip and lockdowns and production interruptions become less frequent.
- The slowdown in economic growth should eventually lower inflation in the service sector and dampen wage growth.
Substantial risk inflation is high
However, the magnitude of the surge in inflation has taken central banks and markets by surprise, and there is still great uncertainty about the outlook for inflation. Inflation may decline faster than central banks expect, especially if supply chain disruptions ease and global policy tightening leads to a rapid decline in energy prices. and goods.
Even so, inflation risks appear strongly on the upside. There is a substantial risk that high inflation will become entrenched and inflation expectations will become unanchored.
Inflation rates in services – for everything from housing rents to personal services – appear to be rising from already high levels, and are unlikely to come down quickly. These pressures can be reinforced by rapid nominal wage growth. In countries with strong labor markets, nominal wages could begin to rise rapidly, faster than firms could reasonably absorb, with the associated increase in unit labor costs being passed on to prices. Such “second-round effects” would translate into more persistent inflation and higher inflation expectations. Finally, a further escalation of geopolitical tensions that triggers another spike in energy prices or worsens existing disruptions could also generate a longer period of high inflation.
While the market data on “average” inflation expectations discussed above may seem reassuring, markets appear to be putting significant odds on the possibility that inflation will significantly exceed central bank targets in the coming years. . Specifically, markets are signaling a strong likelihood that inflation rates above 3% will persist in the coming years in the US, Eurozone and UK.
Consumers and businesses have also become increasingly concerned about upside inflation risks in recent months. For the United States and Germany, household surveys show that people expect high inflation over the next year and are placing considerable odds on the possibility that it will significantly exceed the target in over the next five years.
Stronger tightening may be required
The cost of reducing inflation can be significantly higher if upside risks materialize and high inflation takes hold. In this case, central banks will have to be more resolute and tighten more aggressively to cool the economy, and unemployment will likely have to rise significantly.
Amid signs of already weak liquidity, a more rapid tightening of policy rates could lead to another sharp decline in risk asset prices, affecting equities, credit and emerging market assets. The tightening of financial conditions could well be disorderly, testing the resilience of the financial system and putting particularly strong pressure on emerging markets. Public support for tight monetary policy, now solid with inflation hitting multi-decade highs, could be undermined by rising economic and employment costs.
Nevertheless, the restoration of price stability is of paramount importance and is a necessary condition for sustained economic growth. One of the main lessons from the high inflation of the 1960s and 1970s is that growth that is too slow to contain it leads to much more costly subsequent tightening to reanchor inflation expectations and restore policy credibility. It will be important for central banks to keep this experience firmly in mind as they embark on the difficult path ahead.