Buckle up — the inflation battle is entering a new phase

There is a fair chance that by the time the trees come into leaf in Washington, Frankfurt and London, this decade’s inflation crisis will definitively be over. The eye of the storm has already passed and prices have been rising at rates no higher than central banks’ targets in recent months.

In the six months between May and November last year, for example, the annualised rate of consumer price inflation was only 0.6 per cent in the UK and 2.7 per cent in the eurozone. Excluding volatile energy and food prices, annualised core rates of inflation were 2.4 per cent in both economic areas over the same period. In the US, the equivalent measure — the Federal Reserve’s favoured personal consumption expenditure deflator — was just 1.9 per cent with a headline rate of 2 per cent.

All central banks need, therefore, to bring inflation rates in line with their targets is to avoid a deterioration in price control in the US and UK and to effect a small improvement in the eurozone. If so, they can declare victory.

It goes without saying that the rapid demise of inflation on both sides of the Atlantic in the second half of 2023 was as surprising as its prior increase. Last summer, the Fed, European Central Bank and Bank of England all expected inflation to remain above target until 2025 at the earliest.

While the improvement in outlook has been welcome and remarkable, the legacy of the inflation crisis will not end once prices rise at normal rates again. Evidence suggests the public hated the rise in the cost of living and the arbitrary hassle of the past two years and memories are likely to fade slower than the inflation statistics. Politicians will need to give a better account of the sacrifices made by many than simply telling people that living standards are rising because inflation is down.

With interest rates having risen from an effective zero in 2021 to restrictive levels of 4 per cent in the eurozone, 5.25 per cent in the UK and 5.25 to 5.5 per cent in the US, the battle over rates will also enter a new phase in 2024. Gone is the need to tighten policy: the question for the coming year is how and when to ease the squeeze.

To answer that question, it is proper to start by examining what has been surprising in the decline in inflation so far. Compared with expectations this time last year, the US, eurozone and UK all avoided the recession and rising unemployment that most economists expected. Growth was significantly better in America than Europe, but the supply side of economies on both sides of the Atlantic exceeded expectations. This suggests central banks do not have to restrict demand growth as much as they once thought.

Central bank officials generally accept that they will be bringing interest rates down in 2024, but are reluctant to move quickly for fear of financial market excess — and a remaining risk that inflation is not fully defeated.

There is a difficult trade off here. It’s necessary to wait some time before cutting interest rates so as to ensure that the price trends of the past six months are not a false dawn. Pay growth also needs to come down, although central bankers should allow some temporary catch-up in real wage levels to reflect both the productivity gains and lower import prices that benefited many countries in 2023.

But since monetary policy works with a lag, the longer the delay, the more costs associated with waiting. The first Federal Reserve rate cut should therefore take place in March as financial markets expect. The ECB and Bank of England would be wise to follow a similar timescale rather than hang back, especially as Europe’s economy is weaker and more prone to an unnecessary downturn. So far, officials on both sides of the Atlantic have been unwilling to suggest such timely action is possible.

If financial markets are correct in suggesting the desirability of an early rate reduction, they have gone too far in suggesting interest rates will decline almost as quickly as they rose, pricing in 1.5 percentage points of reductions in both the US and eurozone this year. Unemployment is low everywhere, there is little spare capacity and so there is a danger that inflation will reignite if economies are run too hot.

Central banks would therefore be wise to start easing quickly but not move too fast unless economies appear to be heading for a deep recession. They need to find a gentle path towards relatively neutral interest rates to neither stimulate nor restrict economic growth and inflation. This level is unknown but is not necessarily much lower than the official rates that prevail today and certainly not near zero.

This caution should apply even if inflation falls temporarily below zero in the months ahead, for example if energy prices were to drop significantly. Lower prices of imports for consumers would allow higher incomes and greater consumption and would not be a sign of impending economic collapse.

If the past few years have taught us anything, however, it is that expected scenarios are likely be buffeted by events outside the control of policy. The most important attribute for central bankers this year therefore will be flexibility in the face of inevitable forecast errors and an ability to communicate the need for policy to adapt to changing circumstances. It is wonderful that high inflation has been defeated. The difficult new world starts now.

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