Why Inflation Around the World Just Won’t Go Away

FRANKFURT—The world’s central banks underestimated inflation last year. They are trying not to make the same mistake twice.

Across affluent countries, central bankers are sharply lifting inflation forecasts, penciling in further interest-rate increases and warning investors that interest rates will stay high for some time. Some have set aside plans to keep interest rates on hold.

Roughly a year into their campaign against high inflation, policy makers are some way from being able to declare victory. In the U.S. and Europe, underlying inflation is still around 5% or higher even as last year’s heady increases in energy and food prices fade from view. On both sides of the Atlantic, wage growth has stabilised at high levels and shows few signs of steady declines.

Indeed, the impact of the past year’s aggressive interest-rate increases seems to be ebbing in places, with signs that housing markets are stabilising and unemployment is resuming its decline. Growth softened in the eurozone, which has entered a technical recession, but the economic bloc still added nearly a million new jobs in the first three months of the year, while the U.S. economy has recently added some 300,000 jobs a month. Canada, Sweden, Japan and the U.K skirted recessions after growth unexpectedly rebounded. Business surveys suggest a relatively buoyant outlook.

All that puts major central banks in a tricky spot. They need to decide if inflation has stalled way above their 2% target, which could require much higher interest rates to fix, or if inflation’s decline is only delayed.

Get the call wrong, and they could push the rich world into a deep recession or force it to endure years of high inflation.

“It’s not an enviable situation that central banks are in,” said Stefan Gerlach, a former deputy governor of Ireland’s central bank. “You could make a major mistake either way.”

The difficulty is compounded by central banks having missed the rise of inflation in the first place, he said. These so-called policy errors hurt the standing of officials and might lead them to second-guess their decisions, as both sides of the inflation debate battle over why economists have been so wrong-footed on inflation.

The Federal Reserve last week held interest rates steady but signalled two more increases this year, which would lift U.S. rates to a 22-year high. Price inflation in core services excluding housing, a closely watched gauge of underlying price pressures, “remains elevated and has not shown signs of easing,” the Fed wrote in its semiannual monetary policy report last week.

Central banks in Australia and Canada recently surprised investors with interest-rate increases, the latter after a months-long pause. The European Central Bank last week increased interest rates by a quarter percentage point and indicated it would continue to push them higher at least through the summer. “We are not thinking about pausing,” ECB President Christine Lagarde said.

The Bank of England showed a readiness to pause its long series of interest rate rises since the start of the year, but it is now expected to raise its key interest rate for a 13th consecutive time this week as wage and consumer-price growth prove sticky. Investors anticipate five further rate increases that would take the bank’s key rate to 5.75%.

“We’ve still been going up, the ECB is still going up, everybody’s still going up, and the U.S. economy is still ripping along for the most part,” Fed Governor Christopher Waller said on Friday in a moderated discussion in Oslo.

British lawmakers have been running low on patience. The committee of lawmakers responsible for scrutinising the central bank Tuesday called for an independent review of its inflation forecasts, with a view to finding out what went wrong.

With economic signals mixed, central banks are entering a new phase: They need to wait long enough for past rate rises to filter through the economy without underestimating inflation again.

There are good reasons to wait. For one thing, the savings accumulated by households and businesses during the pandemic might have supported spending and countered the impact of rising borrowing costs. Businesses are highly profitable, which has enabled them to retain workers in a tough economy. As savings are depleted, spending will fall and inflation might resume its decline.

Interest-rate increases might also only just be starting to bite. Businesses and households might not respond when borrowing costs increase from zero to 1%, but they might cut spending more when rates rise to 5%. “It might be highly nonlinear,” said Gerlach.

Crucially, economies are still recovering from the pandemic. The delayed reopening of China’s economy supported growth around the world and might get a boost with fresh stimulus measures.

Many close-contact services such as restaurants and retail still have room to rebound following their huge plunge during the period of lockdowns and social distancing, according to Holger Schmieding, chief economist at Berenberg Bank. In the U.K., output of consumer-facing services is still 8.7% short of its prepandemic level, while the output of all other sectors is 1.7% higher.

Stronger spending on consumer-facing services will damp the impact of interest-rate rises for a time. But those effects won’t last long if economic growth continues to soften, which should reduce incomes and spending.

“The main point now is the transmission of our past monetary decisions, which are strongly reflected in financial conditions, but whose economic effects could take up to two years to be fully felt,” said François Villeroy de Galhau, who sits on the ECB’s rate-setting committee as Bank of France governor, on Friday.

Other considerations, however, suggest that inflation could remain sticky.

Some Fed officials believe that interest rates are hitting the economy more quickly than in the past, meaning that previous increases may already have worked through the system—and even more are needed.

Why might that be? Central bankers now state clearly what they are doing and what they intend to do in future, enabling investors to react immediately, Waller argued on Friday. In rate-hiking cycles as recently as the 1990s, the Fed didn’t even inform investors of its latest policy decisions. As a result, the yield on 2-year U.S. Treasury notes had increased by 200 basis points in March 2022, before the Fed increased rates at all, Waller said.

Moreover, new central-bank policies might damp the impact of interest-rate increases. Bundesbank economists argued in a recent paper that as rates rise, banks are earning more on their large stock of excess reserves parked with central banks, which reflect central banks’ large-scale asset-purchase programs. That helps banks to continue to extend loans.

Crucially, businesses and households might have adjusted to a new world of soaring prices by permanently changing their behaviour. If so, it could be very costly to return to the old world of low and stable inflation, requiring much higher interest rates, said Joerg Kraemer, chief economist at Commerzbank in Frankfurt.

Households and businesses need to respond aggressively or risk deep losses in purchasing power. Businesses can easily justify increasing their prices further if everyone else is doing the same. Trade unions are fighting to compensate employees in ways not seen in decades and attracting new members.

These changes mean that central banks will need to act more forcefully, pushing economies into a deeper downturn to break the new inflationary mind-set, Kraemer said. The ECB, for example, might need to increase its policy rate to 5% from the current level of 3.5%, he said.

For now, investors appear to doubt the hawkish tone emanating from central banks. Stock markets are resilient on both sides of the Atlantic, and investors are pricing in interest-rate cuts in the U.S. and Europe next year. That may be a mistake, according to some economists.

“The bottom line is that inflation at 5% remains too high, and it is clear that markets are under appreciating the Fed’s commitment to get inflation back to 2%,” said Torsten Slok, chief economist at Apollo Global Management.