Finally, there are signs that global inflationary pressures may be peaking. Ex-factory prices and shipping rates are decreasing. Food prices are falling and natural gas prices in Europe have fallen sharply from August highs. With international supply chain issues and commodity price spikes underpinning accelerating inflation this year, headline numbers have also fallen. In the United States, annual price growth has been falling since June, and last month euro zone inflation fell for the first time in 17 months. While these are undeniably positive omens to close out 2022, the task for central bankers will not become particularly easy.
Central banks in the developed world have been raising interest rates to dampen demand and crush inflation with alacrity this year. They had three criteria in mind for their breeding cycle: how fast, how far and for how long. With inflation showing signs of reaching a peak, it makes sense that central banks would consider slowing the pace, if only to assess inflation developments. After a string of strong 75 basis point hikes, US Federal Reserve Chairman Jay Powell hinted at potentially lower hikes to come. The European Central Bank and the Bank of England could follow suit. How far they should go together is the million dollar question – or maybe the $1.1 million question, adjusted for inflation.
Even if inflation peaks, it does so near four-decade highs. Now is not the time to hold or cut rates. Global pressures may be easing, but core inflation, which excludes energy and food prices, remains elevated, especially services prices, which are driven by wage growth. A higher cost of credit would limit domestic demand pressures. Although inflation expectations have waned and there have been some emerging signs of easing labor market tensions, central banks are right to be wary of continued high prices. The U.S. labor market remains hot, with hiring and wages beating expectations last month.
Monetary policy theorists suggest central banks should raise rates above “neutral,” beyond which they have a contractionary effect on the economy. Although estimates vary and change over time, by some metrics the BoE and the Fed may already be there with the ECB closing in. Even when that tipping point is reached, how far to go and at what level to stay is complicated. It’s unclear how much possible recessions next year – stoked by high prices – will drain demand, just as the lagged effects of rate hikes are also accumulating.
The more interest rates rise, the more central bankers will be wary of breaking everything. Housing and capital markets have experienced rapid rises this year, and tensions are mounting. Many unknowns, including the evolution of the war in Ukraine and the possibility of a rebound in Chinese demand for goods and energy next year, particularly if it further eases Covid-19 restrictions, mean that many upside inflation risks remain. As the Fed and BoE shed their bond holdings, via “quantitative tightening,” which the ECB is also considering, it is also uncertain how changes to central bank balance sheets could impact inflation. and financial stability.
A potential spike in price pressures is welcome, however, after a catalog of bad inflation news throughout 2022. For now, it may be wise for central bankers to slow the pace of their rate hikes. rates, pending clearer evidence that domestic price pressures are cooling before stabilizing. It will also be important to be alert to global shocks. Getting the interest rate choreography right won’t be easy. Although inflation has peaked, one thing is certain: it is far too early to declare it defeated.
