This op-ed was first published in The Times – 05th June 2023
Pause, peak or pivot? This is the policy issue facing big western central banks. Should they pause in their tightening cycle? Or raise interest rates further to a new peak? Or pivot, preparing to cut rates soon?
The attention of financial markets is on the imminent meeting of the US Federal Reserve. In turn, this will have some bearing on events here.
The global backdrop has shifted. The world economy lacks momentum. The United States is at a tipping point: aggressive rises in US interest rates over the past year are now likely to be followed by a credit crunch triggered by the recent banking crisis. This will weaken its economy. A recession is possible, but it may be shallow, given present jobs growth.
China also faces headwinds. After rebounding strongly earlier in the year, recent data is two-speed: solid services and sluggish manufacturing. One in five young people are unemployed. All this suggests steady, not rapid growth. Meanwhile, Europe, the sluggish region of the world economy, faces a mixed picture and Germany is already in recession.
In this environment, global inflationary pressures are easing. Oil prices are low. Food prices, while high, are off their peak and are set to decelerate. As we saw last week in Europe, this is leading to significant falls in inflation, which should allow better but far from strong growth there later in 2023.
Bond yields globally have risen already in response to central bank tightening. What now? There is a growing opinion reflected in the markets that the Fed should lift rates by another 0.25 per cent in June. Historically, there is a short gap between US rates peaking and the first subsequent cut. Hence the markets are not ruling out a pivot to cut interest rates this year.
What, then, of the Bank of England? Its previous cheap money policy led to asset prices inflation and fed inequality, led markets to not price properly for risk and allowed zombie firms to survive. Crucially, it helped to feed the recent bout of inflation. While we should seek to avert a return to such policies, it is important to avoid excessive tightening now.
In the eyes of the market, the Bank lacks credibility. Poor communication is only one of its issues. The Bank also has made policy errors that were avoidable. It eased policy as inflation rose and the economy recovered. It was complacent about inflation.
As I pointed out on these pages in 2021, the issue then was which “p” would inflation prove to be. Would the rise in inflation pass through, persist or become permanent? I felt it would persist, and it has. It certainly didn’t pass through quickly, as the Bank had hoped.
Whereas the Bank’s policy was clearly wrong at the time a few years ago, now it faces a far more nuanced judgment call. Our inflation surge was triggered by supply-side factors and lax monetary policy, both of which have been reversed. So inflation will decelerate.
But core inflation is stubbornly high. Moreover, unlike the Fed, which has a twin mandate to achieve low inflation and stable employment, the Bank has a sole 2 per cent inflation target.
The governor has said its model cannot predict inflation well. Thus the market expects rates to peak at 5.5 per cent. One view is that the Bank will only stop increasing rates when core inflation has peaked.
The trouble is that monetary policy acts with a long and variable lag, perhaps 12 to 18 months. There is already significant tightening in the pipeline. Rates have risen from 0.1 per cent to 4.5 per cent and the previous quantitative easing that fed inflation is now being reversed.
The risk is that the Bank, having contributed to higher inflation, now tightens too much and delivers a recession, too. Given this, there is a strong case for a pause in the tightening cycle.