The world’s central bankers have had to manage competing priorities during the COVID-19 era. Now that COVID-related threats to global economic growth look to be receding, the risks from higher inflation are becoming more prominent in their thinking.
In response to persistent elevated inflation, central banks around the world are pivoting toward tighter policy. But the pivot isn’t uniform, because both policy stances and the severity of the inflation shock differ among countries. For instance, although the US Federal Reserve is now moving toward rate hikes, some smaller developed-market central banks have increased rates already, and many emerging-market central banks have tightened significantly.
Bank of England Responds to Rising Inflation Risk
After several weeks of deliberation, the Bank of England recently hiked its benchmark interest rate from 0.1% to 0.25%. With UK inflation reaching a 10-year high last month, a rate hike had started to seem inevitable, and many analysts were surprised that the Bank hadn’t acted sooner. The explanation? Officials noted that their base case was still for inflation to diminish, but the changes to the risk profile around that forecast now warranted tighter policy.
Risk management is a critical function for central banks, and key to understanding how they’re approaching the COVID-19-related inflation spike. While our forecasts—and most others’—show inflation falling back sharply during 2022, the risks aren’t balanced: the probability of inflation staying elevated seems much greater than the probability of inflation falling more than expected.
The Bank’s risk-management stance reflects the fact that rising fuel costs and labor market dislocations are likely to impact inflation in the UK more significantly than in other countries. Even so, the Bank notes that only “modest” policy tightening will be required to curb inflation. We expect two or three more hikes in the first half of 2022.
European Central Bank Faces Different Balance of Risks
In Continental Europe, the European Central Bank (ECB) is taking very gradual steps toward tighter policy and has announced it will halt one of its bond-buying initiatives, the Pandemic Emergency Purchase Programme, in March 2022. But that announcement falls short of true policy tightening, because the ECB will step up purchases by another program—the Asset Purchase Programme. This offsetting action will last for a few months before the ECB tapers its purchases later in 2022.
Slower progress toward tighter policy is appropriate in Europe, where the medium-term balance of risks remains tilted to inflation being too low rather than too high. That balance has become more even recently, and in the short term inflation is likely to be above the central bank’s 2.0% target. But the ECB’s forecasts still show inflation stubbornly below target in 2023 and beyond. We agree—and we currently forecast no rate hikes in the Eurozone across 2022 and 2023. But we recognize that inflation risks have started to influence ECB policy, albeit very slowly.
Shifting Risk Profiles Drive Change in Policy Focus
The recent change of focus toward tighter policy may seem tone-deaf given the current resurgence of COVID-19, although each central bank has been careful to note that the pandemic remains a factor in their analyses. In fact, the changing balance of risks has been the crucial element in their policymaking—it’s become apparent that COVID-generated supply disruptions are hurting economies more than demand reductions.
That thinking could change if governments resort to renewed mobility restrictions, damaging economic activity. But if that doesn’t happen, central banks have concluded that COVID is more likely to push inflation higher than to push growth lower. And as a result, while officials recognize the pandemic’s unpredictable trajectory, they’ve been comfortable moving toward tighter policy. We expect this trend to continue for the next few quarters, which will very likely make 2022 a more challenging year for investors.