Fed and BoE reach for the rates lever but BoJ and ECB decide to sit tight

CHRIS GILES — LONDON COLBY SMITH — NEW YORK MARTIN ARNOLD — FRANKFURT

Central banks almost everywhere face the same bad dream: a mix of slowing growth and inflationary supply shocks that together bode stagflation. So far, they are confronting it in different ways.

Interest rates have already risen in Norway and in many emerging economies, while the US Federal Reserve and the Bank of England have made moves to tighten monetary policy. In contrast, the European Central Bank and the Bank of Japan are sitting tight for now.

The varying responses reflect the difficulty of dealing with what Harvard University’s Megan Greene calls every central bank’s “worst nightmare”; a moment when global forces are slowing growth and increasing inflation.

The orthodox view is that central banks should do nothing to offset inflation caused by a supply shock, such as this week’s rise in oil prices to a seven-year high. As Dhaval Joshi, chief strategist at BCA Research, puts it: “Responding to supply shock-generated inflation with tighter monetary policy is extremely dangerous.”

The problem is that monetary policy typically works by raising or lowering demand. If spending is growing too fast and generating inflation, higher interest rates damp the willingness of companies and households to consume or invest by increasing the cost of borrowing.

The same is not true when prices are rising because supply chains have broken, energy prices are increasing or there are labour shortages. In such cases, monetary policy is ill-suited to dealing with the shock.

As Andrew Bailey, governor of the Bank of England, has said: “Monetary policy will not increase the supply of semiconductor chips, it will not increase the amount of wind (no, really), and nor will it produce more HGV drivers.”

Sometimes restrictive monetary policy has worked. During the 1970s oil shock, Bundesbank action kept inflation from becoming ingrained in the economy. West Germany’s central bank got it right then, Otmar Issing, former ECB chief economist, has written, as its stance gave “unambiguous guidance to other economic decision makers as well as the public and, over a period of three years, kept a firm sense of direction”.

Yet in 2011, when the ECB aped the Bundesbank by raising interest rates during a food and energy supply shock, it made what is now seen as a catastrophic error that worsened the eurozone crisis. In 2011, there were no knock-on effects from the supply shock, so the rise was unnecessary and damaging.

Ten years on, global central banks face a similar dilemma: tighten too soon and they could snuff out recovery; tighten too late and inflation could become entrenched. In the US, Jay Powell, Fed chair, admitted last week it had been surprised by the intensity of supply bottlenecks. Yet the Fed has also said it will “look through” the ensuing price rises given its belief they will fade over time. That view is backed by longer-term market measures of inflation expectations.

“What would transform this into a more pernicious and dangerous situation,” said David Wilcox, a senior fellow at the Peterson Institute for International Economics and a former Fed staffer, “would be if there is a break in the inflationary psychology” that led to companies raising prices and wages in the expectation of similar moves by competitors. This could then snowball into a “toxic” situation where inflation expectations spiral higher.

With the US economy forecast to expand almost 6 per cent this year, and interest rates near zero levels, Fed officials have already signalled at least three interest rate increases before the end of 2023. Whether an earlier move is required depends in part on whether companies adapt to tight supply chains and higher costs by raising their prices, setting off an inflation chain reaction.

“It is something I am spending a lot of time thinking about,” Raphael Bostic, Atlanta Fed president, said last week.

In the UK, the BoE is focusing on the labour market. If it sees wages rising without productivity improving, this may signal demand is persistently stronger than supply. In that case, it has indicated monetary action may be needed. In the eurozone, where unemployment is higher than the UK and labour shortages less acute, there is a slightly different approach. Christine Lagarde, ECB president, last week distanced the institution from other central banks’ shift towards tighter monetary policy, despite EU inflation hitting a 13-year high.

Still, Lagarde said it was important to “look through temporary supply-driven inflation, so long as inflation expectations remain anchored” and wages do not spiral upwards. She added there were few signs of either, yet.

How long that remains the case is an open question. Clemens Fuest, head of the Ifo Institute, said: “We do not see wage settlements that would [lead to] higher inflation, but at the same time the unions are waking up and calling for higher pay.”

In Japan, the central bank, which has long fought deflation, would consider a rise in inflation and inflationary expectations caused by a supply shock to be helpful. Given the uniqueness of the global economic shock wrought by Covid-19, the speed with which growth in major economies is slowing and inflation is rising, and the difficulties of dealing with stagflation, there are likely to be many further twists and turns in central bank policy.

‘Monetary policy will not increase the supply of chips, it will not increase the amount of wind and nor will it produce more HGV drivers’