Business Analyst - August 9
Tuesday, August 9, 2022Soaring inflation puts CentralBanks on a difficult journeyCEntrAL banks in majoreconomies expected asrecently as a few monthsago that they could tightenmonetary policy verygradually. Inflation seemed to be drivenby an unusual mix of supply shocksassociated with the pandemic and laterrussia’s invasion of ukraine, and it wasexpected to decline rapidly once thesepressures eased.now, with inflation climbing tomulti-decade highs and price pressuresbroadening to housing and otherservices, central banks recognize theneed to move more urgently to avoid anunmooring of inflation expectationsand damaging their credibility.Policymakers should heed the lessonsof the past and be resolute to avoidpotentially more painful and disruptiveadjustments later.the Federal reserve, Bank ofCanada, and Bank of England havealready raised interest rates markedlyand have signaled they expect tocontinue with more sizable hikes thisyear. the European Central Bankrecently lifted rates for the first time inmore than a decade.Higher real rates to help pushdown inflationCentral bank actions andcommunications about the likely pathof policy have led to a significant rise inreal (that is, inflation-adjusted) interestrates on government debt since thestart of the year.While short-term real rates are stillnegative, the real rate forward curve inthe united States—that is, the path ofone-year-ahead real interest rates oneto 10 years out implied by marketprices—has risen across the curve to arange between 0.5 and 1 percent.this path is roughly consistent witha “neutral” real policy stance thatallows output to expand around itspotential rate. the Fed’s Summary ofEconomic Projections in mid-Junesuggested a real neutral rate of around0.5 percent, and policymakers saw a 1.7percent output expansion both thisyear and next, which is very close toestimates of potential.the real rate forward curve in theeuro area, proxied by German bunds,has also shifted up, though remainsdeeply negative. that’s consistent withreal rates converging only gradually toneutral.the higher real interest rates ongovernment bonds have spurred aneven larger rise in borrowing costs for“To illustrate, marketbasedmeasures ofinflation expectationspoint to a return ofinflation to around 2percent within the nexttwo or three years forboth the United Statesand Germany. Centralbank forecasts, such asthe Fed’s latestquarterly projections,point to a similarmoderation in the rateof price increases, asdo surveys ofeconomists andinvestors.consumers and businesses, andcontributed to sharp declines in equityprices globally. the modal view of bothcentral banks and markets seems to bethat this tightening of financialconditions will be enough to pushinflation down to target levels relativelyquickly.to illustrate, market-basedmeasures of inflation expectationspoint to a return of inflation to around2 percent within the next two or threeyears for both the united States andGermany. Central bank forecasts, suchas the Fed’s latest quarterly projections,point to a similar moderation in therate of price increases, as do surveys ofeconomists and investors.this seems to be a reasonablebaseline for several reasons:the monetary and fiscal tighteningin train should cool demand both forenergy and non-energy goods,especially in interest-sensitivecategories like consumer durables. thisshould cause goods prices to rise at aslower pace or even fall, and may alsopush energy prices lower in the absenceof additional disruptions in commoditymarkets.Supply-side pressures should ease asthe pandemic relaxes its grip andlockdowns and production disruptionsbecome less frequent.Slower economic growth shouldeventually push down service-sectorinflation and restrain wage growth.Substantial risk inflationruns highHowever, the magnitude of theinflation surge has been a surprise tocentral banks and markets, and thereremains substantial uncertainty aboutthe outlook for inflation. It is possiblethat inflation comes down morequickly than central banks envision,especially if supply chain disruptionsease and global policy tighteningresults in fast declines in energy andgoods prices.Even so, inflation risks appearstrongly tilted to the upside. there is asubstantial risk that high inflationbecomes entrenched, and inflationexpectations de-anchor.Inflation rates in services—foreverything from housing rents topersonal services—appear to be pickingup from already elevated levels, andthey are unlikely to come down quickly.these pressures may be reinforced byrapid nominal wage growth. Incountries with strong labor markets,nominal wages could start risingrapidly, faster than what firmsreasonably could absorb, with theassociated increase in unit labor costspassed into prices. Such “second roundeffects” would translate into morepersistent inflation and rising inflationexpectations. Finally, a furtherintensification of geopolitical tensionsthat ignites a renewed surge in energyprices or compounds existingdisruptions could also generate a longerperiod of high inflation.While the market-based evidenceon “average” inflation expectationsdiscussed above may seem reassuring,markets appear to put significant oddson the possibility that inflation mayrun well above central bank targets overthe next few years. Specifically, marketssignal a high probability of inflationrates of over 3 percent persisting incoming years in the united States, euroarea and the united Kingdom.Consumers and businesses havealso become increasingly concernedabout upside inflation risks in recentmonths. For the united States andGermany, household surveys show thatpeople expect high inflation over thenext year, and put considerable odds onthe possibility that it runs well above
Tuesday, August 9, 2022target over the next five years.More forceful tighteningmay be neededthe costs of bringing downinflation may prove to be markedlyhigher if upside risks materialize andhigh inflation becomes entrenched. Inthat event, central banks will have to bemore resolute and tighten moreaggressively to cool the economy, andunemployment will likely have to risesignificantly.Amid signs of already poor liquidity,faster policy rate tightening may resultin a further sharp decline in risk assetprices—affecting equities, credit, andemerging market assets. thetightening in financial conditions maywell be disorderly, testing the resilienceof the financial system and puttingespecially large strains on emergingmarkets. Public support for tightmonetary policy, now strong withinflation running at multi-decadehighs, may be undermined bymounting economic and employmentcosts.Even so, restoring price stability isof paramount importance, and is anecessary condition for sustainedeconomic growth. A key lesson of thehigh inflation in the 1960s and 1970swas that moving too slowly to restrainit entails a much more costlysubsequent tightening to re-anchorinflation expectations and restorepolicy credibility. It will be importantfor central banks to keep thisexperience firmly in their sights asthey navigate the difficult road ahead.“Amid signs of alreadypoor liquidity, fasterpolicy rate tighteningmay result in afurther sharp declinein risk asset prices—affecting equities,credit, and emergingmarket assets. Thetightening infinancial conditionsmay well bedisorderly, testing theresilience of thefinancial system andputting especiallylarge strains onemerging markets.
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Tuesday, August 9, 2022
Soaring inflation puts Central
Banks on a difficult journey
CEntrAL banks in major
economies expected as
recently as a few months
ago that they could tighten
monetary policy very
gradually. Inflation seemed to be driven
by an unusual mix of supply shocks
associated with the pandemic and later
russia’s invasion of ukraine, and it was
expected to decline rapidly once these
pressures eased.
now, with inflation climbing to
multi-decade highs and price pressures
broadening to housing and other
services, central banks recognize the
need to move more urgently to avoid an
unmooring of inflation expectations
and damaging their credibility.
Policymakers should heed the lessons
of the past and be resolute to avoid
potentially more painful and disruptive
adjustments later.
the Federal reserve, Bank of
Canada, and Bank of England have
already raised interest rates markedly
and have signaled they expect to
continue with more sizable hikes this
year. the European Central Bank
recently lifted rates for the first time in
more than a decade.
Higher real rates to help push
down inflation
Central bank actions and
communications about the likely path
of policy have led to a significant rise in
real (that is, inflation-adjusted) interest
rates on government debt since the
start of the year.
While short-term real rates are still
negative, the real rate forward curve in
the united States—that is, the path of
one-year-ahead real interest rates one
to 10 years out implied by market
prices—has risen across the curve to a
range between 0.5 and 1 percent.
this path is roughly consistent with
a “neutral” real policy stance that
allows output to expand around its
potential rate. the Fed’s Summary of
Economic Projections in mid-June
suggested a real neutral rate of around
0.5 percent, and policymakers saw a 1.7
percent output expansion both this
year and next, which is very close to
estimates of potential.
the real rate forward curve in the
euro area, proxied by German bunds,
has also shifted up, though remains
deeply negative. that’s consistent with
real rates converging only gradually to
neutral.
the higher real interest rates on
government bonds have spurred an
even larger rise in borrowing costs for
“To illustrate, marketbased
measures of
inflation expectations
point to a return of
inflation to around 2
percent within the next
two or three years for
both the United States
and Germany. Central
bank forecasts, such as
the Fed’s latest
quarterly projections,
point to a similar
moderation in the rate
of price increases, as
do surveys of
economists and
investors.
consumers and businesses, and
contributed to sharp declines in equity
prices globally. the modal view of both
central banks and markets seems to be
that this tightening of financial
conditions will be enough to push
inflation down to target levels relatively
quickly.
to illustrate, market-based
measures of inflation expectations
point to a return of inflation to around
2 percent within the next two or three
years for both the united States and
Germany. Central bank forecasts, such
as the Fed’s latest quarterly projections,
point to a similar moderation in the
rate of price increases, as do surveys of
economists and investors.
this seems to be a reasonable
baseline for several reasons:
the monetary and fiscal tightening
in train should cool demand both for
energy and non-energy goods,
especially in interest-sensitive
categories like consumer durables. this
should cause goods prices to rise at a
slower pace or even fall, and may also
push energy prices lower in the absence
of additional disruptions in commodity
markets.
Supply-side pressures should ease as
the pandemic relaxes its grip and
lockdowns and production disruptions
become less frequent.
Slower economic growth should
eventually push down service-sector
inflation and restrain wage growth.
Substantial risk inflation
runs high
However, the magnitude of the
inflation surge has been a surprise to
central banks and markets, and there
remains substantial uncertainty about
the outlook for inflation. It is possible
that inflation comes down more
quickly than central banks envision,
especially if supply chain disruptions
ease and global policy tightening
results in fast declines in energy and
goods prices.
Even so, inflation risks appear
strongly tilted to the upside. there is a
substantial risk that high inflation
becomes entrenched, and inflation
expectations de-anchor.
Inflation rates in services—for
everything from housing rents to
personal services—appear to be picking
up from already elevated levels, and
they are unlikely to come down quickly.
these pressures may be reinforced by
rapid nominal wage growth. In
countries with strong labor markets,
nominal wages could start rising
rapidly, faster than what firms
reasonably could absorb, with the
associated increase in unit labor costs
passed into prices. Such “second round
effects” would translate into more
persistent inflation and rising inflation
expectations. Finally, a further
intensification of geopolitical tensions
that ignites a renewed surge in energy
prices or compounds existing
disruptions could also generate a longer
period of high inflation.
While the market-based evidence
on “average” inflation expectations
discussed above may seem reassuring,
markets appear to put significant odds
on the possibility that inflation may
run well above central bank targets over
the next few years. Specifically, markets
signal a high probability of inflation
rates of over 3 percent persisting in
coming years in the united States, euro
area and the united Kingdom.
Consumers and businesses have
also become increasingly concerned
about upside inflation risks in recent
months. For the united States and
Germany, household surveys show that
people expect high inflation over the
next year, and put considerable odds on
the possibility that it runs well above
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