There is a lively debate over how long central banks will continue to increase their policy rates. Clearly lots of ground has been covered by the world’s major central banks in order to rein in inflation, but there is the widespread expectation that more needs to be done to ensure that inflation will remain low, and as close as possible to their pre-pandemic and pre-war target levels. Let’s look at the three major central banks, knowing well that other G10 central banks have followed and will continue to follow a similar pattern.
The US Federal Reserve has started its tightening cycle sooner than any other developed economy’s central bank (though after some key emerging market central banks, which moved in anticipation of the Fed’s decision in order to avoid a repetition of the “taper tantrum” of 2013-14). The Fed started to increase rates in March 2022, and has brought their Fed funds target range from 0-0.25% to 5.00-5.25%. This tightening cycle has had some effect, as both headline and core inflation have dropped, according to various gauges. For example CPI is now at 3.0% and core-CPI is at 4.8%. But as the labour market remains resilient and wage growth quite dynamic, the Fed has signalled that it intends to increase rates at least another couple of times before year end, with July being the first of such occasions.
The ECB started increasing rates later than the Fed and from a lower starting point, as the deposit rate was -0.5% at the beginning of the campaign. Now the deposit rate is at 3.5% and the ECB has already announced that it intends to hike rates again in July. With headline inflation at 5.5% and core inflation at 5.4 % the ECB will likely continue increasing rates into the autumn, and possibly winter. September remains a possible time for a rate increase.
The Bank of England continues to be in the most complicated situation, as inflation remains stubbornly high, a result not just of the Ukrainian war-induced energy shoc, but also of the self-inflicted Brexit, which now a large part of the population is regretting. Headline inflation is at 8.7% and core inflation 7.1%. In June, when headline inflation remained at 8.7% instead of falling to 8.4% as expected, the Bank of England decided to increase rates by 50bps instead of the 25bps anticipated by market participants. Now it’s clear that the BoE will increase rates again in H2 2023, starting from August, and a cumulative increase of Bank Rate to 6% is almost certain by year-end.
So, all major central banks will increase rates further in coming months, and – after having reached their “terminal rates” – they will keep rates at a high level for a period of time longer than the market currently expects, just to make sure that they have finished the job of killing this sort of inflation, which has proven to be much stickier than was initially anticipated.
But the real question is: will central banks manage to bring inflation down to their original targets, on a sustained basis? Central banks can certainly temporarily bring inflation down, possibly to even below their targets, especially when base effects work in their favour. But in the medium term, inflation is likely to remain higher than initially thought, and certainly higher than pre-pandemic and pre-war levels, for the various reasons we have discussed on previous occasions (such as the tech and ecological transition, de-globalisation, the balkanisation of global supply chains, and the re-distribution of income from capital to labour). And so the question is whether central banks will make an extra effort to bring inflation down from 3-4% to their target of 2%.
We do not think it is the case that they will, as the price in terms of loss of output and increase in unemployment is too high for any central bank to bear, however independent they may be. Even if they are politically independent, central banks do not want to be responsible for adding further fuel to the electoral competitiveness of populist parties, which thrive from this combination of high inflation and sluggish growth.
This does not mean that central banks will ask for an upward revision of their inflation targets. Nor will governments rush to do so, as they do not want to be accused of having failed on their promise of reining in inflation. They will likely de-facto accept an above target inflation, patiently waiting for the system to adjust to the new price level and hoping that this will remain a one-off adjustment process, rather than a continued feature of the next few years.
