Policymakers ‘behind the curve’ as calls grow for slow rises in interest rates and end to quantitative easing
Financial markets fear the world’s leading central banks are risking “economic disaster” by misjudging the threat of rising inflation and not turning off the stimulus taps that have flooded the global economy with money.
From the Federal Reserve to the European Central Bank, policymakers are grappling with a surge in prices not seen for decades while trying to keep wobbly economies on course to recovery from the ravages of the coronavirus pandemic.
While central banks stick largely to the mantra that inflation is “transitory” and price pressures on everything from timber to turkeys will ease in the coming months, economists, business leaders and investors are ringing alarm bells.
They fear that without swift action, such as a rise in interest rates, runaway inflation – which has not been seen in developed economies since the early 1980s – will become so embedded by next year that a policy switch will be too late to have any effect. At the very least, they see this as critical moment to end the massive money-printing schemes that were ramped up to counter a pandemic recession.
Julian Jessop, an independent economist who has worked at the UK Treasury and City firms, said most central banks were “well behind the curve” and that rising costs throughout the supply chain, such as in shipping, would continue to put upward pressure on prices well into next year.
“Central banks need to respond to changing economic conditions,” he said. “The recession that justified the additional quantitative easing and keeping interest rates at emergency lows is over.”
Given that interest rates were at record lows, modest increases “would not be an economic disaster, but should help to prevent one”, Jessop added.
“Interest rates and borrowing costs are still likely to remain near historical lows – especially real rates, after allowing for inflation. In reality, central banks would simply be taking the foot off the accelerator, rather than slamming on the brakes.”
Poland, where inflation hit 6.8% in October, its highest for 20 years, has decided to go on the attack immediately. The Polish prime minister, Mateusz Morawiecki, said on Thursday that the government would cut tax on fuels and energy from December, and would offer bonuses to the hardest hit households.
Describing the move as an“anti-inflation shield”, he said it would cost the government about 10bn zlotys (£1.8bn) and that additional funds would come from spending cuts.
Morawiecki blamed inflation, which hit 6.8% in October, its highest since 2001, on greater energy costs, saying they stem from Russia’s gas policy, the European Union’s climate policy and CO2 emission certificate prices, as well as on bonuses that were paid out to help businesses survive the Covid-19 pandemic.
Prices have risen on foods, fuels and energy. “We are offering a large reduction of tax, in order to cushion the effects of the inflation,” Morawiecki said, adding that inflation may still rise in the winter months of December to March.
Inflation has been stalking the global economy for months but has burst into the open in recent weeks. The 6.2% jump in US inflation in the year to October stunned markets and highlighted huge increases in the cost of some consumer basics, such as a 46% rise in petrol prices and 11% for meat, fish and eggs. In the UK, inflation is running hot at 4.2%, pumped up by record natural gas prices.
With pandemic-induced supply constraints set to continue for months and a wave of pent-up Covid consumer cash chasing a limited flow of goods, claims by the chair of the Federal Reserve, Jerome Powell, that inflation is transitory look increasingly hollow.
Chris Watling, the chief executive and founder of the advisory firm Longview Economics, agrees that central banks risk being caught out.
After the financial crisis of 2008, they pursued loose monetary policy and tight fiscal policy in the form of quantitative easing and spending cuts. Now they have “loose monetary and loose fiscal”, with too much money chasing too few goods.
“They will wake up one day in catch-up phase,” he said. “Perhaps late next year, or 2023, and then they’ll end up tightening quite quickly when prices are rising. And if you tighten into that situation, a bubble, it will burst. So it’s a real challenge for them.”
Mohamed El-Erian, global economist at insurance group Allianz, said that if the Fed were to leave it too late to increase rates, the US – and perhaps the world – could be pushed into recession. “Such a tightening would potentially coincide with three other contractionary forces in the US: a tightening of market financial conditions, the absence of any additional fiscal stimulus, and the erosion of household savings.”
It is a precarious tightrope for policymakers. Inflation can swiftly undermine business and consumer confidence, but going too hard could jeopardise recovery and could also seriously spook booming property markets in countries such as the US, UK and Australia.
El-Erian said policymakers should also consider broader changes to boost productivity, and improvements to the oversight of financial stability risk, particularly in the non-bank sector.
Some central banks are already preparing to jump off the tightrope, most notably the Bank of England, which came close to raising interest rates earlier this month. The ominous US inflation number means policymakers seem certain to take the plunge and increase rates by 0.25 percentage points to 0.35% when they meet again in the first week of December.
Rising prices have exposed central bankers’ “King Canute” theory of inflation, the former governor of the Bank Mervyn King said this week in a strong attack on how policymakers around the world have reacted to the Covid-19 crisis.
New Zealand does not often grab markets’ attention, but this week the country’s Reserve Bank announced the second rate rise in as many months in an effort to cool inflation that hit 4.9% last month. Across the Tasman Sea, the Reserve Bank of Australia reiterated its belief that rates would not go up from their record low of 0.1% until 2023 at the earliest, but the markets are betting on them being 1% this time next year. Lenders are voting with their feet though, with the largest bank, the Commonwealth, on Friday hiking fixed rates for the third time in six weeks.
South Korea’s central bank followed New Zealand’s example, announcing a rise to 1% – its second increase of the year – amid concern over higher living costs. The country’s inflation rate jreached 3.2% in October, a near-10-year high.
Alex Joiner, the chief economist at IFM Investors in Melbourne, said central banks were trying to wait it out and “hope against hope” that pressures from the pandemic would continue to ease, with supply issues resolving themselves.
“They are trying to temper market expectations but the problem is that markets are not believing them,” he said. “Market pricing is aggressive, with investors showing that they think rates will go up.”
The cautiously optimistic Fed view prevails for now, and both Joiner and Watling point to signs of easing in supply chains. The benchmark for world shipping costs, known as the Baltic index, has been falling, and China is beginning to overcome the power shortages that hurt its giant manufacturing sector in September.
However, there is also the possibility that everyone has underestimated the extent of structural changes in the global economy that started in recent years and have been accelerated by Covid. These could mean there is never a return to the Goldilocks era when inflation and growth were both “just right”.
John Studzinski, the managing director and vice-chair of Pimco, the world’s biggest bond trader, told a recent Bloomberg forum that higher inflation could persist for three to five years. Supply chains need to be re-established as the world emerges from the pandemic crisis, he said, and with some deglobalisation of trade, inflation “could be very volatile”.
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