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
target over the next five years.
More forceful tightening
may be needed
the costs of bringing down
inflation may prove to be markedly
higher if upside risks materialize and
high inflation becomes entrenched. In
that event, central banks will have to be
more resolute and tighten more
aggressively to cool the economy, and
unemployment will likely have to rise
significantly.
Amid signs of already poor liquidity,
faster policy rate tightening may result
in a further sharp decline in risk asset
prices—affecting equities, credit, and
emerging market assets. the
tightening in financial conditions may
well be disorderly, testing the resilience
of the financial system and putting
especially large strains on emerging
markets. Public support for tight
monetary policy, now strong with
inflation running at multi-decade
highs, may be undermined by
mounting economic and employment
costs.
Even so, restoring price stability is
of paramount importance, and is a
necessary condition for sustained
economic growth. A key lesson of the
high inflation in the 1960s and 1970s
was that moving too slowly to restrain
it entails a much more costly
subsequent tightening to re-anchor
inflation expectations and restore
policy credibility. It will be important
for central banks to keep this
experience firmly in their sights as
they navigate the difficult road ahead.
“Amid signs of already
poor liquidity, faster
policy rate tightening
may result in a
further sharp decline
in risk asset prices—
affecting equities,
credit, and emerging
market assets. The
tightening in
financial conditions
may well be
disorderly, testing the
resilience of the
financial system and
putting especially
large strains on
emerging markets.
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