High inflation a growing challenge for central banks and for growth

Current high inflation may be a headache for central banks, but for some households it may mean significant financial hardship.

Just six months ago there was a case to make for an upside scenario for developed economies driven by a consumer boom. We aren’t at the stage of looking at consumer-driven recessions, but challenges to the recovery in general and consumer spending in particular have grown.

Labour market recoveries continue and we should see robust nominal wage growth: In the Euro area, the unemployment rate is at record lows. In the UK, the latest REC/KPMG Report on Jobs signalled a further tightening in job candidate availability. In the US, recent payroll gains have been strong. Business surveys signal difficulties hiring and labour as an increasingly constraining factor holding back output.

Some of the tightness in labour markets should fade to the degree it is Covid-related, from temporary problems with Covid-related worker absences to some workers’ fear of returning to consumer facing jobs.

However, as economic output levels grind higher, employment levels should rise on a sustainable basis too. In the meantime, other sources of labour market shortages may linger problematically, pushing wage growth higher during expansions including: early retirement (labour market participation among older age groups fell during the pandemic and has only partly recovered in a number of economies); and lower/less market responsive immigration (likely to be a particular issue in the UK which has undergone a huge change in immigration regime post-Brexit).

However, for now at least, pay growth is not keeping up with inflation. This isn’t just a UK problem, where the latest regular pay growth figure (average weekly earnings) was under 4%Y, but the latest consumer price inflation figure was 5.5%Y. In the UK at least, this situation is set to worsen in the near-term as inflation isn’t expected to peak until April. Some households have scope to dip into their stock of savings to prop up consumer spending – the level of bank deposits that households hold still looks relatively high post-pandemic. Some households can also save less each month. However, the savings rate is already back down to the average seen since the Global Financial Crisis (GFC) in the UK and only slightly above pre-pandemic levels in US.

My forecasts still assume that inflation hasn’t peaked quite yet in many major economies, but that it cools over much of 2022 into 2023. My projections, however, as with those of many economists – have been ratcheting higher as inflation continues to surprise on the upside including in response to recent strong – and stronger than expected – January Consumer Price Index (CPI) prints (7.5%Y in the US, 5.5%Y in the UK and 5.1%Y in the Euro area).

The drivers of current levels of high inflation could mostly still be called transitory, perhaps more accurately ‘lingering, but ultimately transitory’. Energy prices and supply chain issues for example still look responsible in one way or another for much of the upswing over the last 12 months. December and January business surveys tentatively suggest that supply chain issues have eased a touch. Once Covid fades, we should see further improvements – companies adapt over time, supply chains adapt and re-route, and companies re-organise. Some of the tightness in supply chains may have been driven by inventory build; at some point though, inventories will reach a level that companies are happy with. If supply chains improve and some price increases are reversed, CPI could even fall more than expected.

However, that doesn’t mean that we have yet eliminated the risk of inflation settling above the levels seen pre-pandemic and above central bank targets.

Beyond the labour market as a potential source of more sustainable inflationary pressure, I will continue to watch inflation expectations. When household and business inflation expectations rise significantly to high levels, then what were temporary shocks to inflation can become more permanent. Medium-term inflation expectations have already risen significantly in a number of major economies, including the UK and US, and are at levels not seen for a decade.

Very high recent inflation prints raise the risk that inflation expectations move even higher. That would be one thing if we saw it in Japan with its history of low inflation. It isn’t going to be a welcome thing for the Bank of England (BoE), for example, where the UK doesn’t have a history of struggling with inflation that is too low.

In response to all this, central bank stances continue to shift. There isn’t much central bankers can do to sort out strained supply chains or high energy prices. However, central banks can try and calm inflation expectations through their actions and commentary. They can also help bring aggregate demand and constrained supply back into line by raising rates and softening demand growth. Clearly that is not the most appealing outcome when economies are not fully normalised and when more people are still unemployed than pre-pandemic. However, as output moves above pre-pandemic levels and unemployment rates continue to fall, tightening monetary policy becomes an easier decision. Central banks feel they can and should act to keep inflation expectations anchored.

Rate rises are likely to be relatively limited though, partly reflecting where equilibrium interest rates are. I currently assume a 5-10 year ahead equilibrium interest rate of (only) around 1.75% in the UK, for example. Central banks will also run down their balance sheet and the Federal Reserve (Fed), for one, appear to see a degree of substitutability between quantitative tightening and rate rises.

For now though, developed economy central banks have barely got going with monetary policy tightening. I am expecting at least two more 25bp rate rises this year from the BoE and at least three rate rises from the Fed – more likely four after the recent CPI print and with the probability of a 50bp rate rise in March growing. In the absence of more and stronger pushback against market pricing, it now seems sensible to pencil in a rate rise from the European Central Bank (ECB) in the second half of the year too. While inflation is high and rising, risks to these forecasts are in the direction of more rate rises and more front-loading of rate rises than currently pencilled in.

Can the economy take higher interest rates? There is a real risk that central banks push rates too far too fast for the real economy. However, the risk is easy to overstate at the moment, especially where central banks are still using words like “steadily” (Fed Chair Powell in the late January press conference) and “gradual” (ECB President Lagarde) when it comes to their likely monetary policy tightening profile.

Here in the UK, consumer sensitivity to policy rate increases should be substantially less than in some previous periods given that around 80% of the stock of mortgages are currently fixed rate and that the level of household debt to income has fallen since the financial crisis. The current macro-prudential policy framework only emerged post-GFC and includes affordability tests for new mortgages and a limit on the number of high loan-to-income mortgages.

For now, higher prices and lagging wage growth look like the much bigger problem for households to manage, though the combination of tighter monetary and fiscal policy won’t help. Regardless of whether we see one or four rate rises from central banks this year, the case for consumer-spending-driven economic strength has been significantly damaged.

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