Central bankers talk tough, but they can’t fight inflation like this | Philip Inman


Ccentral bankers appear on stage like army generals these days. They brag about their firepower and claim they will crush inflation, their longtime adversary. No quarter will be given in the war. The indirect damage will be high.

A week on Thursday, the Bank of England will raise interest rates for the seventh time since last December, likely to 2.25%, signaling the message to financial markets that Threadneedle Street is not done with its quest to beat inflation.

The conclusion must be that more interest rate hikes are on the way, possibly to 3.5% or even 4% from today’s 1.75%, pushing average mortgage rates to more than 6%.

With the CPI jumping to 10.1% in July, there was little doubt among most City analysts that the bank would raise borrowing costs at its next meeting and continue raising them into next year.

Meanwhile, European Central Bank chief Christine Lagarde said Thursday that “decisive action needed to be taken” after an unprecedented 0.75 basis point increase in euro zone interest rates to 1.25%.

Jerome Powell, the head of the US Federal Reserve, might as well have been wearing army fatigues in his recent appearances, such is his newfound swagger. He told a meeting of central bankers in Jackson Hole, Wyoming, last month that the Fed would use its tools “vigorously” until prices were under control.

Last week he was back on the warpath, saying he would act “really, strongly” before adding: “We’re going to keep at it until the job is done.”

Powell and Lagarde are joining Bank of England governor Andrew Bailey to argue for action based on the premise that higher interest rates can suppress inflation in the current system, fueled primarily by higher energy prices and a spillover to higher transport and food prices.

Burdensome borrowing costs will also counteract so-called second-round effects that come from workers demanding high wage increases to compensate for inflation’s negative impact on living standards.

These arguments are undermined by a lack of supporting evidence, prompting the conclusion that central bankers have been pushed into macho positions by politicians who want the banks to grab while sitting on their hands and by conventions of economic thinking.

Economic theory says that high inflation encourages consumers to increase spending rather than risk hanging on to cash that will be worth less in a year’s time. Higher borrowing costs tame this impulse.

But recent research shows that shoppers know that high inflation is a pretty good signal of a troubled economy, and their response is to cut back on spending and increase savings. They may want a new job and a raise, but the fear of a recession makes them hold on to the job they have and swallow the offered raise.

The latest S&P Global survey of the UK jobs market showed that wage growth in August had fallen to the lowest level since March. Why March? Because that’s when the workers were convinced that the pandemic was over and things were looking up.

It gets worse for the central banks when we look more closely at the nature of the inflation, which is mostly imported. The majority of the affected imports are essential goods such as energy and food. People and companies must buy energy and food, so monetary policy has little effect on the quantity purchased.

Supply shortages are another factor driving up shop prices, but if that problem can be traced back to Covid-19 lockdowns at Chinese factories, then interest rises in the UK will again have no effect.

Catherine Mann, the former chief economist of the American investment bank Citigroup, gives another reason to raise interest rates sharply. She says that as long as the Fed and ECB pull, so must the Bank of England, otherwise the pound will fall towards parity with the dollar.

Her point is that in a competitive world, funds flow to where interest rates are highest, and that is the US, where the base rate is already in a band between 2.25% and 2.5%. She says a falling pound invites further inflationary pressures, given how much Britain relies on imports. So unless the MPC acts tough it will be left behind and so will the pound.

Yet this stance merely underscores that all central banks have lost the plan – to raise interest rates based on scant evidence that it will have the necessary effect. Low interest rates encourage reckless speculation; in an ideal world, prices would be high enough to make financial institutions think twice before gambling, mostly in real estate.

In a crisis, however, low interest rates are a saving grace, especially when so many people and businesses have been encouraged to burden themselves with high levels of debt.

So before they give themselves a medal, central banks should recognize that the means to reduce inflation are in the hands of others.



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