Early this year, the US Federal Reserve placed financial markets on notice that interest rates are finally likely to start rising from March. This triggered speculation that the European Central Bank might also consider a rate increase later this year. In the UK, the Bank of England nudged its central rate up to 0.5% in February – the second rise in three months, in response to rising cost of living pressures.
Fuelled by supply chain disruption as well as soaring food and energy prices, inflation this year will average 3.9% in advanced economies and 5.9% in emerging and developing markets, the International Monetary Fund predicts. But some economists warn that, in a post-pandemic world, an insistence on stabilising inflation could risk overtightening monetary policy, potentially sacrificing growth.
After decades of demand-driven inflation, prices are now surging because of supply constraints – a “marked shift” in the landscape, according to the BlackRock Investment Institute (see Viewpoint, p19). “Monetary policy cannot stabilise both inflation and growth – it has to choose between them,” it said. “We think central banks should live with supply-driven inflation, rather than destroy demand and economic activity – provided that inflation expectations remain anchored.”
In January, Federal Reserve chair Jerome Powell told lawmakers that inflationary pressure was coming mainly from the supply side. Adrian Brown, senior adviser at asset management firm MJ Hudson, said ‘excess savings’ built up by UK and US households during lockdowns – thought to approach 15% of GDP – shows that the role of pent-up demand should not be underestimated. “But inflation might be driven more by supply constraint in the UK, because, on top of global factors – Covid-19 and deglobalisation of supply chains – we have the Brexit effect,” he said.
The trade-off between growth and prices has left the Bank of England in a difficult position. “It is facing a dilemma – tighten now and dampen economic growth or leave policy loose and potentially face a price-wage spiral,” said Nicholas Keeling, client director at local authority treasury management adviser Arlingclose. “Re-anchoring inflation expectations will likely require more extensive tightening later on. Given the risks around the latter, it has chosen the former.”
Public bodies will see the cost of debt increase on the back of increased interest rates, but those managing pensions may be able to invest in assets generating higher returns. “For treasury managers, the effect of increases in bank rate depends on how you are positioned – short- or long-term borrower or investor, or a combination of these positions,” Keeling said.
Central banks need to signal that they are serious about inflation targets, said former chief UK economist at Commerzbank Peter Dixon. Otherwise, investors will question their credibility – and even the extent to which inflation is under the control of monetary authorities. “Since cutting interest rates during the crisis to support the economy, they have got every justification for tightening policy slightly as things normalise,” he said.
“Central banks have claimed the credit for low inflation over the past 30 years but, in reality, that was owing more to exogenous factors that had nothing to do with them, such as the rise of China. Maybe this is when the emperor’s new clothes are seen not to be as shiny as central banks have portrayed them to be.”
US economist Stephanie Kelton said inflation is driven by a complex and dynamic range of underlying factors. “It takes a certain hubris to assert that by nudging a single price – the central bank interest rate – higher, the entire economy can be shifted back onto a stable inflation path,” she said.
