London
CNN
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One of the main jobs of central banks is to keep prices under control so that households and businesses can plan for the future with some certainty what things will cost.
When post-pandemic inflation started to rise – surprising many policymakers – and then exploded when Russia invaded Ukraine, institutions like the Federal Reserve, the European Central Bank and the Bank of England had serious work ahead of them.
These three major central banks are on safer footing as they prepare for their first meetings of the year after a rapid-fire series of large rate hikes in 2022. Headline inflation appears to be falling and hopes are growing that it could raise the cost of borrowing in the coming months.
But the toughest decisions may be ahead as prices are still rising much faster than before the pandemic.
“The inflation news is encouraging, but the battle is far from over,” wrote Pierre-Olivier Gourinchas, chief economist at the International Monetary Fund, in a blog post this week.
Policymakers face tough questions about exactly when to pause rate hikes. Wait too long and a painful recession could result. If you act too early, high inflation could hit back.
The timing of the pivot is further complicated by the low visibility of the fallout from last year’s announced rate hikes, which were the strongest in decades. The Fed has hiked interest rates from near zero to a range of 4.25% to 4.5%. The key interest rate of the European Central Bank is 2% and that of the Bank of England is 3.5%. All are the highest since the 2007-2008 financial crisis.
It will take time for the full impact of these moves to be felt in the economy, even as housing markets and consumers and businesses suffer the mood takes a hit.
“We didn’t see all of these lagging effects happening,” said Vivek Paul, UK chief investment strategist at BlackRock Investment Institute.
The latest inflation data looked promising. In the United States, Annual inflation has fallen every month since June, reaching 6.5% in December. In Europe and the UK, where energy costs are more affected by the war in Russia, annual inflation has fallen to 9.2% and 10.5% respectively.
But there are still enough reasons for caution. According to the IMF, core inflation, which excludes volatile food and energy prices, appears not to have peaked in many countries, raising the risk that price increases could impact the wider economy. And inflation in France rose in January after the government scaled back some energy subsidies, showing how weak gains in Europe have been.
This is urging central bankers to maintain their tough tactics, particularly in London and Frankfurt.
“We will remain on course until such time as we have entered restrictive territory long enough for us to bring inflation back to 2% in time,” ECB President Christine Lagarde told the World Economic Forum.
The Fed is expected to announce another quarter-point rate hike on Wednesday. The Bank of England and the ECB are expected to rise another half a percentage point on Thursday.
“These underlying inflationary pressures are not abating in Europe and central banks need to fight them more vigorously,” said James Rossiter, head of global macro strategy at TD Securities.
Policymakers also have to contend with the harsh reality that while inflation can spike quickly, bringing it back down is a longer and more arduous process.
The IMF forecasts that annual average inflation in advanced economies will fall from 7.3% in 2022 to 4.6% this year, before falling to 2.6% next year – still above in several cases the goals of the central bank.
“The simple gains in terms of inflation falling are likely to be made,” said Willem Sels, global chief investment officer at HSBC Global Private Banking.
Still, investors are increasingly confident that major central banks will soon change course. They expect interest rates set by the Fed, Bank of England and ECB to peak by spring this year. At this point, they are expected to hold rates steady while assessing the impact on inflation.
“Central banks are relatively close to the end,” Sels said.
The Bank of Canada, in particular, signaled last week that it would hold interest rates on hold after raising interest rates to a 15-year high. Like the Federal Reserve, it began its rate hike cycle last March.
One challenge, however, is that the full impact is unlikely to be seen until next year.
Take the housing market, which is very sensitive to changes in interest rates and is closely monitored by central bankers. More than 1.4 million households in the UK will need to renew their fixed-rate mortgages this year. Most were set at interest rates below 2%.
If their mortgage costs go up, they could cut back on spending. That could ease inflation, but also increase the risk of a recession. (The UK is the only Group of Seven economy that the IMF is forecasting will contract this year.)
Another big unknown is the job market. The Fed wants to cool down hiring and wage increases, which can add to inflationary pressures. She has acknowledged that “it’s going to be a bit of a struggle to hit the inflation target” and that job losses are the “lesser of two evils,” Rossiter said.
It has some success. US employer added 223,000 jobs in December, the smallest increase in two years. Average hourly wages rose at an annual rate of 4.6% from 5.6% in March. Tens of thousands of layoffs in the tech sector are a grim reminder that Fed policymakers expect unemployment to rise to 4.6% this year from 3.5% at the end of 2022.
But the US job market remains distorted by the pandemic. The number of available jobs remained elevated at 10.46 million in November, higher than economists had expected. Demand for new hires could keep the US job market stronger than the Fed would like for some time.
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