At long last there are signs that global inflationary pressures may be peaking. Factory gate prices and shipping rates are easing. Food prices are cooling, and European natural gas prices have fallen sharply from August highs. With international supply chain snags and commodity price surges underpinning this year’s inflation acceleration, headline numbers have fallen too. In the US, annual price growth has been falling since June, and last month eurozone inflation fell for the first time in 17 months. Though these are undeniably positive omens to close 2022, the task for central bankers will not become notably easier.
Central banks in the developed world have increased interest rates to curb demand and crush inflation with alacrity this year. They have had three criteria in mind for their raising cycle: how fast, how far and for how long. As inflation shows signs of hitting an apex, it makes sense for central banks to consider easing the pace, even if just to assess how inflation develops. After a series of mighty 75 basis points increases, US Federal Reserve chair Jay Powell alluded to potentially smaller rises ahead. The European Central Bank and Bank of England could follow suit. How high they should go altogether is the million-dollar question — or perhaps the $1.1mn question, adjusted for inflation.
Even if inflation is peaking, it is doing so near four-decade highs. Now is not the moment to be holding or cutting rates. Global pressures may be easing, but core inflation, which excludes energy and food prices, is still high — particularly services prices, which are influenced by wage growth. A higher cost of credit would restrain domestic demand pressures. Though inflation expectations have fallen and there have been some nascent signs that labour market tightness may soften, central banks are right to be wary about high prices persisting. The US jobs market remains red hot, with hiring and wages beating expectations last month.
Monetary policy theorists suggest that central banks need to raise rates above “neutral”, beyond which they have a contractionary impact on the economy. Though estimates vary, and change with time, by some measures the BoE and Fed may already be there, with the ECB closing in. Even when this biting point is reached, how much higher to go and what level to stay at is complicated. It is difficult to know just how much possible recessions next year — stirred by high prices — will drain demand, just as the lagged effects of rate rises also pile on.
The higher interest rates go, the more central bankers will be wary of breaking things. Housing and financial markets have stomached rapid rises this year, and stresses are building. Numerous unknowns including developments in the Ukraine war and the possibility of a rebound in Chinese goods and energy demand next year, particularly if it does ease Covid-19 restrictions further, means plenty of upside inflation risks remain. With the Fed and BoE shedding their bond holdings, via “quantitative tightening”, which the ECB is also mulling, it is also uncertain how changes in central bank balance sheets may impact inflation and financial stability.
A potential peaking in price pressures is welcome, however, after a catalogue of bad inflation news throughout 2022. For now, it may be sensible for central bankers to lower the pace of their rates increases, while waiting for clearer evidence that domestic price pressures are cooling before levelling off. Being alert to global shocks will also be important. Getting the interest rate choreography right will not be simple. Though inflation may have peaked, one thing is for certain: it is far too soon to declare it beaten.
