Central banks must remain committed to fighting inflation

In a big week for monetary policy, the US Federal Reserve and Bank of England are under pressure to show they are serious about tackling stubbornly high inflation. Last week’s US inflation figure for August of 8.3% – above expectations and still near 40-year highs – spooked financial markets. A slight drop to 9.9% in the UK in August was also not cause for celebration. While both central banks have raised interest rates rapidly this year to rein in demand, they will set policy this week amid an increasingly fragile growth outlook. The further increase in the cost of credit will hurt already struggling households and businesses, but both central banks will have to hold their ground.

In America, a decline in price growth over the summer after a peak of 9.1% in June had raised some optimism. News of easing global supply chain pressures and high retailer inventories raised hopes that price growth would soon be brought under control. But the case for slowing the Fed’s rate hike at its Wednesday meeting, following its 75 basis point hike in July, did not strengthen. Core inflation – which excludes volatile items like energy and food – rose last month and shows that the US economy is still overheating. The labor market also remains resilient, with strong demand for workers maintaining upward pressure on wages.

The United States, however, has been relatively less affected by the energy inflation that is ravaging Europe. In Britain, the government’s recent plan to cap energy bills for households and businesses, more details of which are due to be unveiled on Wednesday, should help reduce inflation in the near term. But the package – estimated at around £150bn – risks keeping demand and inflation rising over the medium term. This strengthens the case for the Bank of England to continue raising rates decisively on Thursday. Indeed, further stimulus, in the form of tax cuts expected to be unveiled in Friday’s ‘mini-budget’, will also boost spending.

Wage pressures also remain firm in the UK: unemployment has fallen to its lowest level since 1974, while high levels of inactivity continue to weigh on labor supply. Indeed, at 5.5%, wage growth remains incompatible with the BoE’s inflation target of 2%. The pound’s collapse to a 37-year low last week against the dollar, which is adding pressure on imported prices, also means the BoE will have to be wary of falling too far behind the Fed.

The challenge for both central banks is to raise rates as recession risks remain elevated. While the US economy has shown some resilience, business activity has lost momentum. In the UK, the energy package will cushion the impact of soaring energy prices, but many will still have to deal with a trying winter. Global headwinds from the energy crisis in Europe and the ongoing Covid-19 shutdowns in China will also weigh on growth prospects in the months ahead. Higher interest rates will only add to the pain.

Yet the risk of high inflation taking hold is the greatest danger. The longer it stays high, the greater the damage it will do to households and businesses. Although inflation expectations have fallen recently, US consumers still expect it to exceed double the Fed’s target within a year. Many will be looking for officials’ interest rate projections to signal robust monetary policy for the remainder of 2022 and potentially into 2023. Meanwhile, in the UK, public satisfaction with the management of inflation by the BoE recently fell to its lowest level on record.

The two central banks must strengthen their credibility, after falling behind on the inflation curve. It will be important to act firmly and quickly now, especially since the slower growth outlook could make rate hikes more difficult to achieve in the near future.

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