Central banks must remain firm in tackling inflation

In a busy monetary policy week, the US Federal Reserve and the Bank of England are under pressure to show they are serious about tackling stubbornly high inflation. Last week’s US inflation figures of 8.3 percent – above expectations and still near 40-year highs – spooked financial markets. And the slight drop to 9.9 per cent in the UK in August was no cause for celebration. While both central banks have raised interest rates quickly this year to curb demand, this week they will set policy amid increasingly shaky growth prospects. The increased cost of credit will hurt already distressed households and businesses, but both central banks will need to hold out.

In America, lower price growth over the summer from a peak of 9.1 percent in June has led to some optimism. News of easing global supply chain pressures and rising retail inventories gave hope that price growth could be tamed quickly. But the argument that the Federal Reserve would be slow to raise interest rates at its meeting on Wednesday, after its 75 basis point increase in July, has not solidified. Core inflation – which strips out volatile items such as energy and food – rose last month and shows that the US economy remains overheated. The labor market also remains resilient, with rising demand for workers continuing upward pressure on wages.

However, the United States has been relatively less affected by the energy inflation sweeping across Europe. In Britain, the government’s latest plan to reduce energy bills for households and businesses, with more details on the latter on Wednesday, should help bring down inflation in the near term. But the package – estimated to cost around £150 billion – risks keeping demand and inflation higher over the medium term. This strengthens the BoE’s position to continue raising interest rates decisively on Thursday. Indeed, more stimulus, in the form of tax cuts expected to be revealed in Friday’s “mini-budget”, will give a boost to spending as well.

Wage pressures also remain strong in the UK: unemployment has fallen to its lowest level since 1974, while high levels of inactivity continue to strain the labor supply. Indeed, at 5.5 per cent, wage growth is still not in line with the 2 per cent inflation target set by the Bank of England. Sterling’s collapse to a 37-year low last week against the dollar, adding pressure on import prices, also means the Bank of England will need to be wary of pulling back too far from the Federal Reserve.

The challenge for both central banks is to raise interest rates while the risks of a recession remain strong. While the US economy showed some resilience, business activity lost momentum. In the UK, a power package will mitigate the impact of higher energy prices, but many will still be tested for the winter. Global headwinds from the energy crisis in Europe and the ongoing Covid-19 lockdowns in China will also dampen growth prospects in the coming months. Higher interest rates will only add to the pain.

However, the risk of entrenching high inflation is the biggest one. And the longer it stays on the rise, the more damage it will do to families and businesses. While inflation expectations have fallen recently, US consumers still expect it to more than double the Fed’s target within a year. Many will look to officials’ interest rate expectations to point to strong monetary policy for the rest of 2022 and possibly even 2023. Meanwhile, in the UK, public satisfaction with the Bank of England’s handling of inflation has recently fallen to an all-time low.

Both central banks need to boost their credibility, after lagging the inflation curve. Acting firmly and quickly now will be important – especially as the dampening growth outlook could make rate hikes more difficult in the near future.

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