Central banks’ inflation fight still uncertain as risks loom

As major central banks continue to raise interest rates, hoping to tame persistent inflation, it’s becoming increasingly evident that the endgame is still far from clear. Despite policymakers’ best efforts, it’s proving harder than expected to slow down price increases, and analysts are warning that financial markets could break along the way.

The reality of inflation

The U.S. Federal Reserve, the European Central Bank, and the Bank of England are all in the process of raising rates, but they’re all operating under a great deal of uncertainty. They’re approaching the peak interest rate for this round of monetary policy tightening. Still, they support the projection that inflation will slow steadily over the next year or two without damaging economic activity.

Top global policymakers and analysts are skeptical about this view, with many pointing out that a more fragmented global economy is emerging from the COVID-19 pandemic. This will lead to more supply shocks, and monetary policy could face more severe tradeoffs. For example, the International Monetary Fund’s first deputy managing director, Gita Gopinath, said during a forum at the IMF and World Bank spring meetings in Washington that “we are going to be hit by more supply shocks, and monetary policy faces much more serious tradeoffs.”

“No historical precedent”

Her comments were echoed by others who feel that the three top central banks’ narrative of relatively cost-free disinflation rests on shaky ground. The argument that inflation will slow down while avoiding a deep recession is based on the hope that it will behave as well as before. This view still regarded the current wave of inflation as transitory, spurred on by Russia’s invasion of Ukraine and the pandemic.

Gopinath noted that there was “no historical precedent” for high inflation to be squelched without rising unemployment, which raises concerns about the effectiveness of the current approach of raising interest rates.

The prospect of falling inflation

The prospect of inflation falling alongside a gradual return to the pre-pandemic state of affairs is implicit in how central banks frame the path forward. Among the Fed, ECB, and BoE, only the British central bank projects a recession will be needed to slow inflation. The ECB expects to win its inflation battle with no change in the unemployment rate. U.S. prominent bank officials are projecting a modest one-percentage-point rise in the unemployment rate this year from its near-historic low of 3.5% and slow but continued…

Related facts

• The U.S. inflation rate rose by a bigger-than-expected 4.2% year-on-year in April, up from 2.6% in March, as the economy rebounded strongly from its pandemic slump.
• Jerome Powell, the U.S. Fed’s chairman, has said that inflation has increased notably and will likely remain elevated in the coming months before moderating. However, he believes it will eventually return to the Fed’s 2% goal.
• The ECB will likely accept inflation temporarily overshooting its target of just below 2% following next week’s policy meeting as it focuses on supporting the pandemic recovery.

Key takeaway

Central banks’ fight against inflation remains uncertain as risks continue to rise. Despite policymakers’ best efforts, it’s becoming increasingly evident that slowing down price increases is more complicated than expected. Inflation could persist longer than anticipated, leading to a choice between higher and longer-lasting inflation or a deep recession to fix it. As a result, central banks may have to do more than expected, and financial markets could still break along the way.

Conclusion

Central banks’ battle against inflation is a challenge as policymakers face persistent labor shortages, global supply cleavages, and shaky financial markets. As the pandemic reshapes the global economy, destabilizing factors such as supply shocks and trade wars will likely increase. As a result, there is a clear need for central banks to remain cautious and realistic when framing their projections and assessing risks. They must be prepared for the possibility that inflation could persist longer than anticipated.