Inflation: Central Banks’ Dilemma

Navigating Inflation: Central Banks Face a Delicate Balancing Act

Following the recent coronation bank holiday, the UK now turns its attention to the Bank of England (BoE), as its Monetary Policy Committee (MPC) is anticipated to increase rates by 0.25%, taking the UK’s base rate to 4.5%. In the previous week, Jerome Powell of the US Federal Reserve (Fed) and Christine Lagarde of the European Central Bank (ECB) both adopted a hawkish tone while raising rates by 0.25% to 5.25% and 3.25%, respectively, which was in line with expectations.

US employment data continues to be encouraging, with recent non-farm payroll figures showing no signs of decline. Despite some job losses in cyclical sectors, gains in industries like healthcare and education have balanced the overall picture. This resilience indicates that rate-sensitive sectors are not being severely impacted.

At the moment, households are not very sensitive to short-term rate fluctuations. Thanks to pandemic relief payments, short-term debts were reduced, and long-term mortgages were refinanced at lower rates. With jobs remaining abundant, consumption continues at healthy levels, though it is no longer fuelled by excess pandemic savings. However, rate sensitivity is more pronounced among small businesses, real estate, and private equity – all sectors that significantly influence the overall economy.

In recent weeks, risk assets have performed fairly well as global growth indicators improved during the first quarter. Though these indicators have become mixed again, the job market remains strong, making central banks hesitant to introduce rate cuts already factored into bond markets. Small and medium-sized businesses, which have been under pressure for some time, are running out of time. Central banks may wait too long to act, leading to a sudden rush of defaults and bankruptcies among smaller firms.

Similar to the Fed, the BoE is grappling with persistent inflation and concerns over a tight labour market. Governor Andrew Bailey is expected to raise rates by 0.25% next week, with economists predicting that this will be the last hike in the current cycle. Although UK inflation should continue to decline, the economy is too weak to maintain such high levels. Despite a recent halt in falling house prices and the highest consumer confidence figures in over a year, there is little momentum to push UK prices higher in the coming months.

Conversely, the ECB has been slower than its British and American counterparts in addressing inflation. The decision to raise its three key interest rates was mildly doveish. While labour market tightness hasn’t been as pronounced in the EU, inflation has been driven by factors such as the war, Russian gas supply withdrawal, and an energy crisis. With the easing of these issues, it might seem that Europe’s inflation problem has resolved itself. However, as the US economy slows down, the European economy is also expected to weaken during the second half of the year.

Ultimately, inflation is unlikely to decrease unless growth also weakens. The European Union’s fragmented nature, with widely varying political priorities, makes it challenging for ECB President Christine Lagarde to strike the right balance. The ECB has been effective at managing liquidity for many years, but finding the right rate policy mix amidst competing economic needs is a much more complex task. This challenge will likely define Lagarde’s tenure at the ECB.

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