Interest rate dilemma for central banks as inflation rises but growth slows

The Federal Reserve, the ECB and the Bank of England appear unclear on how to tackle inflation amid the Iran war New UK cost of living crisis looms as rising energy bills lift inflation As the Middle East crisis drags on into its sixth month, central banks sit in a tricky position. Oil prices remain at elevated levels, stoking inflationary pressures while also threatening to weigh on growth. The US Federal Reserve, the Bank of England and the European Central Bank are still smarting from the criticism of their inaction in 2022, when inflation soared above 10% in the UK and eurozone and over 9% in the US. Central banks were plagued by accusations that they moved too slowly to confront inflation in the months after the Ukraine war started, when post-pandemic consumer spending was already stoking prices on everything from food to construction materials. Now they are asking whether the continuing throttling of fossil fuel shipping through the strait of Hormuz will mean another year of target-busting prices growth. Last month US inflation edged lower to 3.4%, down from 3.5% in June and 4.2% in May, largely in response to easing petrol prices following the US memorandum of understanding with Iran. Since the Bureau of Labor Statistics collected the data, the price of a barrel of Brent crude has risen again to about $90 – a figure that will push up the price of energy and transport across the US in the second half of the year. Fed officials are asking whether US inflation will climb back towards 4%, double its target. The US central bank’s new boss, Kevin Warsh, has instigated an all-embracing review of its operations based on the advice of 15 outsiders that he says are among the most eminent experts and economists of the age. Many analysts have applauded him for recognising that a series of inflation shocks dating back to the arrival of Covid-19 have undermined the integrity and durability of central bank forecasting. Mohamed El-Erian, an economist and professor at the Wharton Business school, said Warsh recognised that many of the shibboleths of monetary policymaking had proved flawed.

“The key issue for me is having someone there who’s committed to long-overdue Fed reforms. This is essential for future Fed effectiveness, credibility and political independence,”he said. Chief among the tools Warsh has already ditched is forward guidance – the explicit signalling of the likely future path of interest rates. He also declined to join other Fed policymakers in creating dot plots on a graph showing how the economy and inflation are expected to develop over the next couple of years. In his 2022 book Radical Uncertainty, he described forward guidance as “silly” when no central bank knows what the interest rate will be in six months or two years’ time. El-Erian calls forward guidance “spurious accuracy”. What financial markets and the public need to know is the “reaction function”. In other words, how the central bank will respond to different economic developments. Charlie Bean, a professor at the London School of Economics and a former deputy governor of the BoE, said that Warsh’s changes mean that Fed watchers don’t have guidance on either the path of rates or the central bank’s likely reaction to events. “Warsh is getting in a bit of a mess in the way he is not giving a guide to where rates are going and also not talking about how changes in the economy will affect rates,” said Bean. “It means he is not saying anything of substance.” The Fed held rates in July and financial market betting expects a hold again in September, though a rise is thought possible.

Markets anticipate at least one, and possibly two, quarter-point increases by the middle of next year, taking the Fed’s target rate from its current 3.5-3.75% range to 4-4.25%. Will market betting prove reliable? Nobody knows. While the BoE is widely considered to have acted consistently since the start of the Iran war – saying it will raise the cost of borrowing should there be any signs of persistent inflation. However, the decision to hold the Bank Rate steady at 3.75% so far this year could come under pressure. The UK consumer price index (CPI) dropped to 2.6% in June, but some analysts expect it to rise to 2.9% or even 3% when July’s figures are published by the Office for National Statistics on Wednesday this week. A majority of the nine-member monetary policy committee (MPC) are wary of increasing interest rates when it will have little effect on global oil prices, aware that higher borrowing costs could depress an already weak UK economy. Bean says the MPC is also under pressure from even more fundamental trends, including high and rising government debt. This is a problem for the Fed’s Warsh, too – after the US paid the highest borrowing costs to sell 30-year bonds since 2001, in an debt auction this month. Neil Shearing, chief economist at the consultancy Capital Economics, says he has argued for many years that central banks will preside over high inflation for as long as western governments cannot control their debt-fuelled spending.

⚡ Effects Interpreter