Evidence is mounting that many of the drivers behind the dramatic rise in inflation over the past year are fading. European gas prices are now at levels last seen before Russia invaded Ukraine in late February. The cost of shipping a 40-foot steel box from Shanghai to Long Beach has fallen to $1,500 from around $8,300 this time last year. Used car prices have reversed even in the UK where they were once worth more than new cars.
Does this mean less aggression from the world’s central banks in 2023? Not immediately. After pumping too much stimulus into the economy in the early days of the pandemic, and then belatedly realizing the tenacity of the rise in prices, rate setters will start the year the way they ended it — desperately trying to push credibility through Talks restore tough fight against inflation.
This hawkish rhetoric isn’t just about rebuilding trust. While headline inflation rates are falling as the base effects of last year’s sharp rise in energy and food prices fall off the indices, price pressures have not fully abated.
Supply chain stumbling blocks are no longer driving commodity prices up, but service sector and job market trends remain a concern for central banks. And then there are ongoing fears that the pandemic and the flare-up of geopolitical tensions have left the global economy with lower productive capacity than 2019 – which, if true, would mean that rate-setters would have to destroy demand to bring inflation back down to the level of a few years ago.
Whether rate setters will match their tough talk with hefty rate hikes will depend on what the Federal Reserve does next. If 2022 has taught us anything, it’s that the Fed is the invisible hook that hangs the decisions of the rest of the world’s interest rate setters.
Central bankers did not officially work together in 2022. But they might as well have done it. When Jay Powell started raising interest rates last spring, the European Central Bank was still on a wait-and-see stance, and the Bank of England was awaiting the modest quarter-point hikes that central bankers (and their observers) tend to favor. By the fall, both the ECB and the BoE had followed the Fed’s lead and made their own jumbo rate hikes of 0.75 percentage points – a remarkable pace of tightening that shocked investors everywhere. By the end of the year, even the Bank of Japan had delivered its own aggressive surprise.
The U.S. monetary watchdog was able to reconcile the rest through the sheer power of the dollar. Central bankers are reluctant to admit the pressure exerted by FX markets. But the magnitude of the collapse of nearly every major currency against the greenback — the euro was down nearly 16 percent at one point in 2022, the pound more than 20 percent and the yen nearly a quarter — spooked them. Their response was to follow the Fed and Supersize rate hikes.
This year could be one of those rare events when a weak US economy proves not dangerous but a boon for the rest of the world should it ease the pressure on Powell to hike interest rates. When the US Federal Reserve switches from a half point to a quarter point early next year, it will give room for others to follow suit. The danger is that the US jobs market will continue to run hot and the Fed will not ease up. Others would again feel the need to increase its firepower – even though their economies are in far weaker shape.
The big risk for 2023 is that rate setters become so paranoid about losing face that they put their money where their mouths are, and not just talk tough, but push through several big rate hikes. A rapid rise in the cost of borrowing would almost certainly push economies into recession. They could also trigger bouts of financial turmoil that make last fall’s gilt market panic look like a runaway.
Turbulence, as in the case of the Bank of England during the LDI panic, would send mixed signals, forcing policymakers to support individual financial markets while trying to tighten credit conditions. Rate setters would face even more political pressure – in Europe, French, Italian and Finnish leaders have already complained that the ECB’s attempts to curb inflation are jeopardizing jobs and growth and raising the risk of another sovereign debt crisis.
Heeding threats other than inflation would likely result in fewer rate hikes. That, in turn, could mean that prices will continue to rise at 3 or 4 percent a year for the foreseeable future and that the fall in inflation will stop short of the 2 percent target that rate setters want. That’s not ideal. But after a very chaotic 2022, sacrificing the ambitions of a perfect landing for something more prosaic could prove to be the least-worst option for everyone.
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