The men and women in the hot seats at central banks have had it relatively easy in 2022. They would probably disagree but, as inflation rose to the highest levels in 40 years on both sides of the Atlantic, there was always someone else or some other thing that could credibly be blamed.
Whether it was Vladimir Putin’s weaponisation of gas and oil supplies, the Trump and Biden administrations’ overgenerous support to US households, a worldwide surge in goods demand at a time of stretched supply chains or (in the UK) the disastrous Trussonomics experiment, rapidly rising prices often had a proximate cause that left central banks in the clear.
They had to mop up the damage, for sure, raising interest rates far above expectations at the beginning of the year. US interest rate expectations for the end of December 2022, for example, started the year at less than 1 per cent, but ended it at a rate between 4.25 and 4.5 per cent. This revolution in thinking came alongside far higher than expected inflation data and was therefore highly visible and easy to explain.
As we look forward into 2023, inflation in the US, eurozone and UK has almost certainly peaked, though the same cannot be said with certainty for underlying inflationary pressures. Inflation is still in double digits in the eurozone and UK and 7.1 per cent in the US. These levels are way above the central banks’ 2 per cent targets. The declines that have already started are set to accelerate in the coming spring.
Mostly, the drop in inflation will result from base effects as large price rises that occurred this year fall out of the annual calculation. For the US and eurozone, monthly price rises were particularly sharp in March, so headline inflation is likely to fall sharply when the March 2023 figures are published in April. The UK will enjoy a similarly large drop a month later.
Although welcome for politicians and central bankers, rapidly falling inflation rates will demonstrate neither that the inflation crisis is over nor that the 2 per cent target will be easily reached. All three economies have historically low unemployment rates, and there is precious little evidence so far that companies or workers are planning to moderate price increases and wage demands.
Central banks might have done enough with the rate rises they have already put in place, but no one can yet know, given that we have not had a similarly large inflationary episode in recent history. Economic models cannot therefore provide reliable reassurance.
The potential problem is that inflation may be sticky on the way down and may not fall to the 2 per cent target. If so, an above target rate of price increases will become self-fulfilling, increasingly embedded into contracts. This would require central banks to raise interest rates further in a downturn even when headline inflation is moderating from recent peaks.
That is their job. But it is one they have not had to do in recent decades. We don’t know whether officials would have the guts to keep heaping pain on individuals and companies already suffering from falling real incomes at a time when the inflation menace seemed to be evaporating. There is no doubt that this task would be harder than anything they have encountered this year. It would be natural for them to tread cautiously.
The window for higher interest rates is therefore narrow in 2023. Rate rises will become much more difficult after the first quarter of the year. Mistakes are quite likely and these would most likely come when independent officials are already facing criticism for undermining economic prospects amid widespread hardship.
As they look forward to 2023, central bankers will need to retain their normal attributes of intellect in analysing economic data. More than ever, they will also need both nerves of steel and the hides of rhinos.