Fed and ECB still behind the inflation curve
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The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
In the past two weeks, a much brighter light has been shone on how and why the world’s most influential central banks are scrambling to regain control of the inflation narrative and contain further damage to their policy credibility.
The key message coming out of recent meetings of central bank policymakers is that inflation is higher and more persistent than expected — and the risks to their projections are tilted to an ever greater rate of price rises.
It is a major shift for the US Federal Reserve and the European Central Bank which, unlike the Bank of England, maintained a call that inflation was “transitory” for far too long.
Some market commentators have characterised this as a “hawkish pivot”. If it is a pivot, it is partial at best, still too slow and risks an over-compensation later this year. Currently, the two banks’ extremely accommodating policies are inconsistent with both their change in language on inflation and developments on the ground.
Rather than facilitate a smooth transition for monetary policy and the economy, this continued go-slow approach will force both to tighten more this year than they would have had to otherwise. This will amplify worries about how the global economy and markets will cope with rising borrowing costs and prices.
Already concerns about inflationary expectations becoming more embedded are building. There is a risk that price and wage setting shifts from seeking to compensate for the impact of past cost increases to also starting to include an element for future anticipated inflation.
These considerations led the Bank of England to raise interest rates by 25 basis points, the first time it has opted for back-to-back increases since 2004. The fact that four of the five members of the Bank’s policymaking committee preferred an immediate 50 basis points rise suggests that a third consecutive increase at the next meeting is almost a done deal.
What I view as desirable and timely policy moves by the Bank of England stand in stark contrast to ECB and Fed inaction — a disparity that increases the BoE’s policy challenges.
With its policy meeting last month, the Fed should at a minimum have signalled more seriousness in tackling inflation by immediately stopping its large-scale asset purchases.
Even before Friday’s blowout December jobs report, failure to do so had contributed to a remarkable shift in market expectations that centre on five hikes for this year alone, with one prominent bank (Bank of America) forecasting seven. This, in my view, would constitute an excessive tightening of monetary policy given that the Fed is also expected to reduce its bloated balance sheet.
For its part, the ECB should have provided stronger guidance on interest rate rises this year at its policy meeting last week. The markets are already pricing in such increases. The ECB also reiterated its adherence to a “step-by-step” approach to raising rates only after stopping net bond purchases, a move that further reduces its degrees of freedom.
All this increases the possibility of a second central bank policy mistake in as many years. The more the Fed in particular delays, the greater the risk of a summer bunching of monetary policy tightening that unduly suffocates the much needed strong, inclusive and sustainable economic recovery.
An even bigger risk is that such policy tightening would come after inflationary expectations have been de-anchored, resulting in a twin blow — higher prices and lower income. That hits particularly hard the most vulnerable segments of the population. The damage would be amplified if pronounced market volatility spills back into the broader economy.
The consequences of these policy mistakes extend well beyond Europe and the US. They are particularly threatening to developing countries lacking policy flexibility and financial resilience.
It took way too long for the Fed and ECB to correct their misreading of price increases. The additional difficulties this poses are now being compounded by unnecessary delays in altering what remains an inexplicably uber stimulative monetary policy stance. Rather than ensure a soft landing for the economy, the world’s two major central banks are likely to be forced into excessive “catch-up” policy tightenings.
Stubbornly slow and partial now, the policy pivot that is sure to occur in the next few months risks considerable damage to livelihoods.
Letter in response to this article:
Central banks are circumspect on inflation for a reason / From Stefan Gerlach, Chief Economist, EFG Bank, Zurich, Switzerland