Then I was in a small group of economists who believed we were moving to a new era of low inflation and was struck by how long it took market thinking to adjust. When the inflation environment changes, expectations can adjust slowly. It is quite possible that inflation in many western economies, including the US, euro area and the UK, may settle at a higher level than before the pandemic, and above the 2 per cent where markets always seem to expect inflation to return to. If so, expect more policy pressures and market volatility. Markets may thus no longer be able to rely upon monetary policy as being the inevitable shock absorber, where rates are cut in response to economic weakness or financial stress. This is in addition to central banks shrinking their balance sheets. Future monetary policy neutrality points to the need for real positive interest rates. The second key issue warrants more attention. So further rises look likely, with recession possible. In contrast, the Bank of England lacks any credibility and so has not been able to pause. The Fed’s credibility allows it to pause. But it will raise rates if its aggressive tightening to date does not curb core inflation. There is considerable policy tightening in the pipeline that will slow the economy. Rising inflation expectations and tight labour markets are feeding wage growth and companies appear able to pass on higher costs, thus maintaining or boosting profit margins.ĭespite criticism, the US Federal Reserve was sensible to pause. However, second-round inflation effects are feeding into core inflation in economies such as the UK. The initial drivers of this global inflation bout have been reversed, namely supply-side factors and lax monetary policies. The persistence of core inflation is keeping central banks in the west cautious.
It has seen inflation ease to a 25-month low of 4.25 per cent but policy is on hold. While many countries are likely to have seen policy rates already peak, central banks are reluctant to signal easing. The UN’s measure of food prices is 22.1 per cent below its March 2022 all-time high.Ĭhina, which maintained a prudent monetary policy during the pandemic, has just eased and is likely to cut its reserve requirement ratios for banks again, providing liquidity.
Globally, headline inflationary pressures are easing. Tightening through higher policy rates could end soon. One is where rates will peak and whether central banks have done enough to curb inflation. The end of cheap money is the dominant issue, driven by the need to restore anti-inflationary credibility to policy. Markets will need to factor this in fully. Not now, but once we see where core inflation settles. That is, policy rates will need to remain higher than inflation for some time. There needs to be a prolonged period of positive real interest rates in western economies. The writer is chief economic strategist at Netwealth
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