One of the main jobs of central banks is to keep prices under control, allowing households and businesses to plan for the future with some certainty on what things will cost.
So when inflation started to climb in the aftermath of the pandemic — catching many policymakers off guard — and then exploded when Russia invaded Ukraine, institutions such as the Federal Reserve, the European Central Bank and the Bank of England had serious work to do.
These three major central banks are on surer footing as they prepare for their first meetings of the year, following a quickfire series of super-sized rate hikes in 2022. Overall inflation appears to be coming down, and hopes are growing that they could be done raising borrowing costs in the coming months.
But the hardest decisions may be to come, with prices still rising much faster than they were before the pandemic.
“The inflation news is encouraging, but the battle is far from won,” Pierre-Olivier Gourinchas, the International Monetary Fund’s chief economist, wrote in a blog post this week.
Policymakers face difficult questions about exactly when to pause interest rate hikes. Wait too long, and a painful recession could result. Move too soon, and high inflation could come roaring back.
Timing the pivot is made even more complicated by low visibility into the consequences of the steep rate hikes announced over the past year. The Fed has raised rates from near-zero to a range of 4.25% to 4.5%. The European Central Bank’s main rate is 2%, while the Bank of England’s is 3.5%. All are the highest since the 2007-2008 financial crisis.
It takes time for the full effects of these moves to feed through the economy, even as housing markets come under strain and consumer and business sentiment takes a hit.
“We’ve not seen all of those lagged effects materialize,” said Vivek Paul, UK chief investment strategist at the BlackRock Investment Institute.
Inflation is coming down
Recent inflation data has looked promising. In the United States, annual inflation has dropped every month since June, reaching 6.5% in December. In Europe and the United Kingdom, where energy costs are more affected by Russia’s war, annual inflation has slipped to 9.2% and 10.5%, respectively.
But there’s still plenty of reason for caution. According to the IMF, core inflation, which strips out volatile food and energy prices, does not appear to have peaked in many countries, adding to risks that price increases could become embedded across the economy. And inflation in France rose in January after the government rolled back some energy subsidies, showing how tenuous gains in Europe have been.
That’s pushing central bankers to maintain their tough tactics, especially in London and Frankfurt.
“We shall stay the course until such a time when we have moved into restrictive territory for long enough so that we can return inflation to 2% in a timely manner,” ECB President Christine Lagarde said at the World Economic Forum.
The Fed is forecast to announce another quarter-point interest rate hike on Wednesday. The Bank of England and ECB are both expected to hike by another half a percentage point on Thursday.
“You’ve got these underlying inflation pressures not letting up in Europe and central banks having to fight them more forcefully,” said James Rossiter, head of global macro strategy at TD Securities.
Policymakers also have to contend with the harsh reality that while inflation can rocket up quickly, getting it back down is a longer, more strenuous process.
The IMF projects that annual average inflation in advanced economies will fall from 7.3% in 2022 to 4.6% this year, before dropping to 2.6% next year — still above central bank targets in several cases.
“The easy gains in terms of the drop in inflation are probably made,” said Willem Sels, global chief investment officer at HSBC Global Private Banking.
The end is near?
Still, investors are becoming increasingly confident that major central banks will change course soon. They expect rates set by the Fed, the Bank of England and the ECB to reach their peak by this spring. At that point, they’re expected to hold rates steady while they assess the impact on inflation.
“Central banks are relatively close to the end,” Sels said.
Notably, the Bank of Canada signaled last week that it would pause its hikes after raising its key interest rate to the highest level in 15 years. Like the Federal Reserve, it began its hiking cycle last March.
One challenge, though, is that the full impact is unlikely to become apparent until next year.
Take the housing market, which is very sensitive to changes in interest rates and is closely monitored by central bankers. In the United Kingdom, more than 1.4 million households need to renew fixed-rate mortgages this year. Most had been set at interest rates below 2%.
When their mortgage costs rise, they could pull back spending. That could ease inflation, but also boost the risk of recession. (The United Kingdom is the only Group of Seven economy that the IMF predicts will shrink this year.)
Another major unknown is the job market. The Fed wants to cool hiring and wage increases, which can drive up inflationary pressures. It has acknowledged that “there’s going to be a bit of pain to achieve the inflation target,” seeing job losses as the “lesser of two evils,” Rossiter said.
It’s having some success. US employers added 223,000 positions in December, the smallest gain in two years. Average hourly earnings rose at an annual rate of 4.6%, down 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 labor market remains distorted by the pandemic. The number of available positions in November remained elevated at 10.46 million, higher than economists had expected. Demand for workers could keep the American job market stronger than the Fed would like for some time.