Almost in unison, the European Central Bank (ECB), the US Federal Reserve and the Bank of England have put up interest rates by half a percentage point, indicated further rate hikes are on the way and, in the case of the ECB, significantly revised up its inflation projections for the euro zone.
In terms of a sign that the credit cycle had flipped, that the old regime of ultra-easy monetary policy had come crashing down, they don’t come bigger than this.
The ECB, which this time last year was still trumpeting the transitory story of inflation, is now expecting inflation to stay above its target rate of 2 per cent for the next three years. It forecast inflation would average 8.4 per cent this year before dipping to 6.3 per cent in 2023, 3.4 per cent in 2024 and 2.3 per cent in 2025.
It will be higher for longer for a number of reasons but principally because of Russia’s invasion of Ukraine and the impact of pandemic-era stimulus.
Frankfurt’s forecasts are higher than many market analysts have been predicting and reflect the bank’s metamorphosis from inflation sceptic to inflation realist.
They also indicate that even if inflation peaks soon, as ECB chief economist Philip Lane and others suggest, the return to more normal rates of price growth could be grindingly slow.
Markets seem to be reading too much into the lower level of rate hikes – the previous two were 0.75 per cent – seeing them as a sign that central banks are winning the battle against inflation. Policymakers are sounding more cautious, however. ECB president Christine Lagarde said upside inflation risks remained, necessitating further tightening.
“If you compare with the Fed, we have more ground to cover … we’re not slowing down, we’re in for the long game,” she said.
Federal Reserve chairman Jerome Powell said recent signs of weakening inflation had not brought any confidence yet that the fight had been won.
The consequences for the economy of such an extended period of higher price growth and higher interest rates is lower rates of consumption and investment, which in turn mean lower rates of growth.
We’re already seeing the first round of this here with two reports this week from Economic and Social Research Institute (ESRI) and the Organisation for Economic Co-operation and Development (OECD) warning of a sharp slowdown in growth next year on the back of slowing consumption.
From the ECB’s perspective, having inflation higher for longer also risks what it describes as “a de-anchoring of expectations”.
When workers start factoring in higher price levels, they start demanding better wages, which firms pay for by charging higher prices in a sort of self-perpetuating cycle. A wage-price spiral is one of the most damaging trends that can engulf an economy and avoiding this is now a greater priority than avoiding a recession.
This is why central banks, after a slow start, are now moving aggressively against inflation. In just six months, the ECB has lifted its main refinancing rate, the one that affects mortgages, from zero to 2.5 per cent.
“Keeping interest rates at restrictive levels will over time reduce inflation by dampening demand and will also guard against the risk of a persistent upward shift in inflation expectations,” Ms Lagarde said.