Central banks forced to continue raising interest rates despite slowdown after months of dithering

Having spent months convinced price pressures were transitory, policymakers have much to answer for as they scramble to combat inflation
While there is a chance tighter policy can bring down prices sufficiently without causing a recession, it is an increasingly slim one

Nicholas Spiro

Published: 1:30am, 22 Jul, 2022

Why you can trust SCMP

Since the beginning of this year, it has been clear that the world’s major central banks got inflation spectacularly wrong. The members of “ Team Transitory” – the group of leading policymakers who until recently were convinced price pressures were temporary, and would abate once the Covid-19 pandemic subsided – have a lot to answer for.

As recently as last September, the US Federal Reserve was not even sure whether it would raise interest rates this year. While its complacent view of inflation stemmed from a number of factors, one of the most important was the amount of time it took for the Fed and other Western central banks to accept that the 40-year period of subdued prices had come to an end.

However, once policymakers acknowledged the “Great Moderation” – the term used to describe the period of steady growth and inflation since the mid-1980s – had run its course, they fervently embraced tighter policy.

From the moment the Fed signalled last December that it would raise rates at a faster pace than anticipated, a series of aggressive increases in advanced economies ensued. A growing number of central banks, including those in Canada and Australia, have implemented large rate rises of half a percentage point or more. Next week, the Fed is set to increase borrowing costs by at least three-quarters of a percentage point.

Yet, no sooner did central banks pivot towards tighter policy than investors began to fret about growth. In the past several months, the pendulum of market anxiety has swung away from high inflation towards a sharp slowdown.

Bank of America published its latest global fund manager survey on Tuesday. It showed expectations for global growth fell to their lowest level since the poll’s inception in 1994, with most respondents expecting a recession.

Furthermore, there are signs inflation may have peaked at last. In the US, market gauges of inflation expectations in the next five and 10 years have fallen sharply from their highs in April to 2 per cent to 2.4 per cent, only slightly above the Fed’s target.

More tellingly, households’ expectations of where prices will be in five years fell to 2.8 per cent in July, according to the University of Michigan’s latest consumer sentiment survey. That compares with 3.1 per cent in June.

This is in keeping with the sharp drop in long-term bond yields, with the benchmark 10-year US Treasury yield declining to 3 per cent, down from 3.3 per cent in mid-June. This suggests markets do not believe inflation will stay entrenched.

There are also signs in emerging markets that the worst of the inflation shock has passed. Stronger-than-expected rises in prices in major economies were not as widespread and pronounced in June as in previous months, according to JPMorgan data.

02:34

Convenience stores are the new go-to lunch place for South Koreans as inflation soars

Moreover, central banks in developing economies, particularly in Latin America and Central Europe, began raising rates aggressively long before their developed-market peers turned more hawkish and are now showing signs of tightening fatigue.

The shift from an inflation scare to a growth scare has convinced many investors that central banks will lose their nerve. Bond markets are already pricing in rate cuts in the US next year and believe the European Central Bank – which on Thursday is expected to raise rates for the first time in 11 years – will struggle to tighten policy in the face of a severe commodity shock and renewed concerns about Europe’s shaky monetary union.

Yet, the end of the Great Moderation also marks the end of the traditional policy response. While central banks could be relied on to halt or even reverse rate increases if necessary when inflation was subdued, they are no longer able to shift to looser policy to prevent a sharper slowdown because of the imperative of bringing inflation back into normal bounds.

China consumer prices tipped to rise as eased Covid curbs boost demand

Even if prices have peaked, they are not about to come down to acceptable levels any time soon. Core inflation, which strips out volatile food and energy prices, remains high. This is especially true in the US, where rents are rising at their fastest pace in 36 years.

The reason inflation expectations are easing is because of mounting fears about a recession, which are most apparent in battered commodity markets. Yet, having dithered when inflation was becoming embedded in the economy, central banks have no choice but to continue to raise rates even as growth slows sharply.

Right now, there is no trade-off between curbing inflation and suppressing growth. To put the inflation genie back in the bottle, policymakers must slam on the brakes. While there is a chance tighter policy can bring down prices sharply enough without causing a contraction in economic activity, it is an increasingly slim one.

As long as prices remain uncomfortably high – a near certainty for the next year or so – beating inflation is the only game in town for central banks.

Nicholas Spiro is a partner at Lauressa Advisory