The inflation fight: are central banks going too far, too fast?

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With their notes sharpened and their claws on display, the world’s central banks have completely adopted the hawk’s stance this week. Buoyed by sharp rises in interest rates and currency intervention, they have used pointed language to advertise their unique goal of beating the scourge of inflation.

In one of the most sudden shifts in global economic policymaking in decades, central bankers say they are fed up with rapid price increases and are urging them to take action to restore price stability, almost at any cost.

But after a week of dramatic announcements from central banks around the world, at least some economists are beginning to wonder: are they going too far, too fast?

The US Federal Reserve has been by far the most important player in this change of temperament. On Wednesday, it raised its key interest rate by 0.75 percentage point to a range between 3 and 3.25 percent. At the start of the year, this percentage was close to zero.

By raising interest rates, central bankers are trying not to lower the peak inflation caused by rising gas and food prices, but are trying to ensure that inflation doesn’t stay high © Kiyoshi Ota/Bloomberg

The Fed indicated that this was far from the end of monetary policy tightening, with members of the interest rate setting committee forecasting interest rates to end between 4.25 and 4.5 percent in 2022 — ​the highest since the 2008-09 financial crisis.

In the summer, Fed Chair Jay Powell spoke of higher borrowing costs ending with a “soft landing” for the non-recession economy and a gradual decline in inflation. On Wednesday, he admitted that was unlikely. “We need to get inflation behind us. I wish there was a painless way to do that,” Powell said.

The Fed’s plan to curb consumer and corporate spending to reduce domestic inflation has been reiterated elsewhere, even if the causes of high inflation are different. In Europe, extraordinary natural gas prices have pushed headline inflation to similar levels to the US, but core inflation is significantly lower. In emerging economies, declining currency values ​​against the US dollar, which hit a 20-year high this week, have pushed import prices up.

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Sweden’s Riksbank kicked off the copycat campaign on Tuesday with a 1 percentage point rate hike to 1.75%, the largest rate hike in three decades. Switzerland, Saudi Arabia and the UAE also each announced a 0.75 percentage point hike, marking an end for Switzerland to the period of negative interest rates that began in 2015. The Bank of England raised its key rate by 0.5 percentage point to 2.25 percent on Thursday. the highest since the financial crisis, with a near promise of further rate hikes.

Even in Japan, which has long had negative interest rates, authorities felt the need to take measures to curb inflation. The Treasury Department intervened in foreign exchange markets on Thursday to support the yen and limit the rise in import prices. It took what it called “decisive action” to address the strength of the US dollar, which pushed the country’s underlying inflation rate to a highly unusual 2.8 percent in August.

Economists at Deutsche Bank noted that for every central bank around the world that is currently cutting interest rates, there are now 25 banks that are raising interest rates — a ratio well above normal and not seen since the late 1990s. has occurred. many central banks were given the independence to set monetary policy.

Chart showing the 12-month moving ratio of the number of global central bank increases to austerity, indicating that many central banks are raising interest rates

Nathan Sheets, chief of international economics at Citi and a former U.S. Treasury official, says central banks are “acting so fast that they really haven’t had enough time in making these rate hikes to assess the feedback effects on the economy”.

Central bankers are reluctant to admit they made mistakes by keeping interest rates too low for too long, pointing out that these assessments are much easier to make in retrospect than in real time. But they now want to take action to show that even if they were too late to take action on inflation, they will be “powerful” enough to use the word of the Bank of England to curb inflation.

Powell was clear that the US central bank would not fail. “We will continue until we are sure the job is done,” he said on Wednesday. The Swedish Riksbank was characteristically blunt in its assessment. “Inflation is too high,” it sounds. “Monetary policy now needs to be tightened further to get inflation back on target.”

The new stance on monetary policy has developed through 2022 as the inflation problem became more persistent and difficult for central bankers. By the time many gathered in Jackson Hole in August for their most important annual conference, the mood had turned decisively toward greater action now taking place around the world.

Jackson Hole: New York Federal Reserve's John Williams with Fed Governor Lael Brainard and Chairman Jay Powell, who said, 'We need to get inflation behind us.  I wish there was a painless way to do that'
Jackson Hole: John Williams of the New York Federal Reserve with Fed Governor Lael Brainard and Chairman Jay Powell, who said, “We need to get inflation behind us. I wish there was a painless way to do that’ © Jim Urquhart/Reuters

Christian Keller, head of economic research at Barclays Investment Bank, says that “since Jackson Hole, central bankers have decided they want to make the mistake of siding with hawkishness.”

“For the first time in maybe decades, they have become afraid to take control of the [inflation] process,” says Keller, highlighting how central bankers now say they want to avoid the mistakes of the 1970s. Central banks “make decisions that involve a lot of risk and this feels better when everyone is doing it. The result is a synchronized tightening.”

With the new stance, markets are pricing in that by June next year, key interest rates will rise to 4.6 percent in the US, 2.9 percent in the eurozone and 5.3 percent in the UK – forecasts range between 1.5 and 2. percentage point higher than at the beginning of August.

Chart: Market expectations for next June key rates have risen

By raising interest rates, central bankers are not trying to lower the inflation spikes caused outside the US by rising gas and food prices, but rather they are trying to ensure that inflation doesn’t hang at a pace uncomfortably higher than their targets. . This can happen if companies and workers start to expect higher inflation, leading to price hikes and higher wages.

They are willing to make sure there is pain in terms of an economic downturn to show their credibility in meeting their inflation targets.

Sheets says that after misinterpreting inflation last year, central banks would rather exaggerate now. They are balancing the prospects of a recession against the risk of a prolonged period of inflation that would undermine their credibility. “On balance, they feel . . . that is a risk they have to take.”

An added complication is that the models used by central banks – which failed to foresee such rapid price increases as the pandemic subsided and the war in Ukraine began – no longer works well in describing economic events.

A Ukrainian cannon fires at Russian troops.  The models used by central banks — which failed to foresee such rapid price increases as the pandemic subsided and the war in Ukraine began — no longer work well in describing economic events.
A Ukrainian cannon fires at Russian troops. The models used by central banks – which failed to foresee such rapid price increases as the pandemic subsided and the war in Ukraine began – no longer works well in describing economic events © Ihor Tkachov/AFP/Getty Images

Ellie Henderson, economist at Investec, is concerned that “the usual tools and models, which [central bank] analysis, can no longer be trusted as they now operate in parameters outside the range from which they were estimated”.

In this unfamiliar world, Jennifer McKeown, head of global economics at Capital Economics, finds it difficult to argue that central banks go too far.

“While this is the most aggressive tightening cycle in many years, it is also true that inflation is higher than it has been in decades,” she says. “Inflation expectations have risen and labor markets are tight, so central banks are rightly concerned about the potential for second-round effects from energy prices to wages and underlying inflation.”

But an increasing number of economists, led by some big names such as Maurice Obstfeld, former chief economist at the IMF, believe that central banks are now excessive in their actions to raise interest rates and that the effect of all this tightening will be a global tightening. . recession. The World Bank also expressed similar concerns this week.

Antoine Bouvet, an economist at ING, says that “central banks have lost confidence in their ability to accurately predict inflation”, leading them to focus more on current inflation rates.

Women work in an office in Bond Street, London, during the power cuts of 1973-74.  Central bankers now say they want to avoid the mistakes of the 1970s
Women work in an office in Bond Street, London, during the power cuts of 1973-74. Central bankers now say they want to avoid the mistakes of the 1970s © Evening Standard/Getty Images

“Combine this with the fact that they seem to think the cost of overrunning their policy tightening is less than underrunning it, and you have a recipe for over tightening,” he explains. “I would characterize this policy choice as almost design overshoot.”

According to Holger Schmieding, chief economist at investment bank Berenberg, “monetary policy works with a delay, [so] the risk is that the Fed will not realize it has gone too far until it now raises interest rates well above 4 percent,” resulting in unnecessarily long and deep recessions.

But as many economists explain, no one really knows what’s too far and not far enough in this environment. Central banks therefore want to make sure that they eradicate inflation so that they can correct the exchange rate and lower interest rates later if necessary.

Krishna Guha, vice chairman at Evercore ISI, says there is a “serious risk” that central banks overstate the tightening, but argues the Fed is right about doing too much.

“On a global level, but also on a US level, it’s probably better to overdo it than understate it and risk a 1970s redux,” Guha says. “But that, of course, only makes the outcome of exaggeration more likely.”