Article

Central banks prioritise inflation ahead of growth

The point where central banks will see that inflation has peaked and decide their actions and words have had some effect. For the moment, the Fed will remain more hawkish than the markets.

| 4 min read

Interest rates have been rising all around the world. Only in China, with inflation at around 2%, has there been a small fall. Brazil is up to 13.25%, Hungary to 9.75%, Mexico to 7.75%, the Czech Republic at 7%, India at 4.9% and Poland at 6.5%.

The interest rate rises have followed late in the wake of the inflation whose waves have broken now on most shores. After a long period of near-zero interest rates in the advanced countries, the USA has reached 1.75%, the UK is at 1.25%, Korea at 1.75%, New Zealand at 2% and Australia at 1.35%. The Euro-area still stays at 0% but has proposed a 0.25% increase later this month. Japan stays at -0.1%. Traditionally, the US exerts a strong force on rates in many other countries, as they struggle to prevent too fast a devaluation of their currencies should their interest rates fall short of those available in America.

Central banks on the back foot

In most cases, the central banks did not see this inflation coming. The forecasts for 2022 a year or so ago showed relatively-low price rises. The central banks this year have been struggling to catch up with reality and are still having to adjust their inflation forecasts for the current year upwards. The Czech central bank forecasting 2.2% inflation for 2022 now thinks it will pan out at 15% for the year as a whole and may hit 17% this summer. They have raised their two-week repo rate to 7% to try to reduce demand and cut inflationary pressures. Poland with double-digit inflation to has set its rate at 6.5% as it seeks to put a brake on the economy.

The Fed minutes revealed a board still adjusting to the inflation it missed. Last month, it said: “The labour market was very tight, inflation was well above the Committee’s 2% objective and the near-term inflation outlook has deteriorated since the time of the May meeting”. It moved its forecasts of growth down and forecasts for inflation, especially this year, up. The central bank set a 75bp point rise in interest rates to slow the economy and get back closer to target. Its forecasts assume Fed funds reaching 3.4% this year, from 1.75%, and going to 3.8% next year. It accepts this will slow the economy and increase unemployment but sees inflation as the bigger threat.

The Fed staff think real GDP will remain well above potential, which means they think there will still be plenty of inflation to combat.

The Fed thinks its forecasts of inflation may still be too low and its forecasts of GDP may still be too high. The Fed staff think real GDP will remain well above potential, which means they think there will still be plenty of inflation to combat. It notes that African American and Hispanic unemployment is higher than average, a concern to them, but not one that produces any policy softening. No one can doubt the single-minded priority over inflation.

The Fed board willingly voted to reduce its substantial holdings of bonds and mortgage-backed securities. It favours cutting the book by $400bn by the year-end. This is a big reduction in market support at a time of substantial government issuance to fund the deficit.

Positive signs

The positive news for markets are the signs that inventories have been rebuilt and supply constraints are easing. The labour market is not delivering much higher wage settlements and real wages are now declining, producing a slowing in demand. The US housing market is already slowing a lot under the weight of more expensive mortgages. In the Euro-area, there are more marked signs of a slowdown, and there is more stress from the energy and food issues caused by the Russian invasion of Ukraine.

We are getting closer to the point where central banks will see inflation has peaked and decide their actions and words have had some effect. For the moment, the Fed is more hawkish than the markets, reflecting how shaken it has been by its mistakes of last year. The ECB is on a different path as it tries to talk inflation down without putting rates up in ways which could make it difficult for some governments and companies to finance themselves. This leaves the Euro-area more exposed to a bad outcome.

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Central banks prioritise inflation ahead of growth

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