MIKE DOLAN: Stubborn inflation might remain at uncomfortable level for some time

London — Western central banks have been warned this week not to quit in the final lap of their monetary tightening campaign — the hard yards households and financial markets may now find exhausting.

Ever since post-pandemic inflation spikes and 2022’s Ukraine-related energy shock forced the steepest interest rate rises in four decades, investors have been desperate to second-guess their reversal. This year was odds on favourite to deliver.

But despite significant disinflation by midyear, hopes of any rate cuts before 2024 have all but evaporated — with doubts even re-emerging about the timing of the peaks.

The good news is that’s mostly down to a resilience in economic activity and broader financial conditions, encouraging hopes for a relatively “soft landing”.

And yet, desperate for their members not to declare premature victory in getting inflation back to 2% targets or sow an assumption above-target inflation will eventually be tolerated, central bank watchdogs are cheerleading a last push.

The Bank for International Settlements (BIS) — the main global central banking forum — said on Sunday the really hard bit of the tightening process probably starts now as the pain of the credit squeeze gets felt and policy stamina is needed.

“The ‘last mile’ may pose the biggest challenge,” the BIS said, adding that getting inflation back to target from here may prove harder than the first phase of the disinflation journey.

Insisting governments’ fiscal policies must consolidate to complement the process, the BIS report said the final throes of disinflation are challenged by fading base effects, firms and households recouping losses and political pressure to ease off interest rates as financial stresses build with a lag.

However, discussing how long the process typically takes, BIS research showed headline and core inflation rates have historically returned to pre-spike levels or below a little over a year after they peak.

Using the Organisation for Economic Cooperation and Development’s aggregate measure of world inflation, those peaks were probably set in October — indicating they should on that basis be back to target by the end of 2023.

But that’s not in forecasts this time around — with US and UK headline inflation rates not back to target by the end of 2024 and the eurozone not even by then.

The BIS report suggested two features of this inflation episode may draw out the retreat — yet-to-peak services inflation related to the pandemic re-openings and the fact the pace of disinflation has been even slower than in the 1970s, despite a faster pace of rate hikes now.

And the BIS message was echoed by the IMF on Monday.

Speaking at the European Central Bank’s (ECB) annual forum in Portugal, IMF second-in-command Gita Gopinath noted three “uncomfortable truths” about the state of inflation — how core inflation is taking too long to get back to 2% goals, financial stresses risk compromising the battle and how price pressures would be fundamentally different post pandemic.

“Monetary policy should continue to tighten and then remain in restrictive territory until core inflation is on a clear downward path,” she said.

And the BIS and IMF have clearly been heard.

ECB chief Christine Lagarde on Tuesday stressed how eurozone inflation was in a new phase where it could linger higher for longer and the ECB needed to keep policy tight to squeeze out any corporate margin padding or mounting wage pressures.

“This will ensure that hiking rates does not elicit expectations of a too-rapid policy reversal and will allow the full impact of our past actions to materialise,” Lagarde said.

The US Federal Reserve laid out a slightly softer “stay the course” message in chair Jerome Powell’s congressional testimony last week, but New York Fed chief John Williams doubled down on that on Monday.

“Price stability is not an either/or, it’s a must have,” said Williams, arguing strongly against any idea that financial stability worries compromise the conduct of monetary policy.

And this is at the heart of why investors have on so many occasions over the past year wrongly assumed the central banks would balk at ever-tighter credit — most obviously during the US regional bank failures in March.

But right now, money markets don’t see Fed rates significantly lower than they are now until the middle of 2024 — with an interim peak either in July or September.

You have to go out to October 2024 to see pricing of ECB rates any lower than the 3.5% they are now — with another half point of hikes to a peak of 4% by January stitching in before then.

The Bank of England could be stuck at peak rates around 100 basis point higher, near 6%, right through the end of 2024.

How will these elevated horizons eat into financial assets?

Some financial executives think it would be less stressful for investors if rates kicked even higher now, triggered a recession that defused inflation and allowed speedy policy reversal — less stressful at least than a slow burn of dogged inflation and persistently high interest rates.

For those who fear real estate — commercial and office sectors at least — are the next shoe to drop, that timeline could be critical as impaired asset valuations get realised over time and potentially drag the most exposed banks into trouble.

Others think a modest economic downturn may not get central banks back to where they need to be — meaning higher inflation and rates are now being baked in for some time.

“The recession is not going to be big enough to really purge all inflation pressures out of the system,” said Joseph Little, global chief strategist at HSBC Asset Management.

Reuters