A divide in responses to the inflation threat

The large central banks’ responses to surging inflation this week were marked by a divide between anglophone economies and the eurozone. The Bank of England, which surprised markets by holding rates last month, confounded investors again this time by raising them, despite the uncertainties posed by the Omicron coronavirus variant. The US Federal Reserve accelerated tapering of its bond-buying programme and changed its forecast for interest rates, with officials signalling they expected to raise rates three times next year.

The European Central Bank’s decision, by contrast, was more balanced. It announced it would end its emergency quantitative easing programme as it had previously signalled, by March, but promised to increase its regular asset purchase programme to smooth the taper in the second and third quarters of next year. It also extended the period in which it plans to fully reinvest its asset holdings. The outcome is that the ECB’s balance sheet will continue to expand, albeit at a slowing pace, into the medium term.

This divide makes sense. Price rises are broader in the anglophone countries. “Core” inflation, which strips out volatile food and energy prices, is much higher in the UK and US at 4 per cent and 4.9 per cent, against the eurozone’s 2.6 per cent. Pre-pandemic, there were signs the currency bloc was in a Japanese-style low inflation trap. It is too soon to say that it will have escaped it once inflationary factors disappear.

It is striking, however, that no central bank really seems to have changed the (very similar) way they think the economy and inflation work. All three expect inflation to abate in the second half of next year. All cite the same pandemic and supply chain-related factors. In that sense, this week’s decisions should be welcomed as competent.

The slight firming up of UK and US monetary policy should not therefore lead to expectations of a much greater overall amount or speed of tightening than was previously anticipated. These central banks will continue to calibrate policy very finely to how each one’s economy develops. If inflation slows down substantially next year — an optimistic assumption — they may stay put for a while. Conversely, the ECB has positioned itself to move to a tighter stance if inflation remains high.

The flipside of this fine-tuning is that there was little adjustment for the arrival of Omicron. This is probably fair; the variant’s severity is not yet clear. Omicron might yet exacerbate inflationary pressures if it adds to supply chain problems but spending holds up. If things play out badly and demand drops sharply, the US and UK central banks may be forced to change tune, if not to reverse this week’s decisions. That would be the right thing to do, if not the most comfortable position to take.

The week’s decisions illustrate, above all, how hard it is to formulate monetary policy when the outlook is both very uncertain and very volatile. Doing the best they can in going by the data can make central bankers look dithering or indecisive, or weak in the face of pressure. Sticking to one’s analysis can bring accusations of being blind to the obvious — as the Fed has found. Trying, like the Bank of England, to be flexible — if that means upsetting market expectations — leads to being called an “unreliable boyfriend”, though there are questions over how well the BoE had communicated the shifts in its thinking. It had scope to wait for clarity, but chose to raise from a record-low rate to what remains a very low level.

On the whole, the three banks delivered well-reasoned decisions. It is their misfortune that they may look less competent if the pandemic takes another dramatic turn.