Slowing inflation piles pressure on central banks to pivot

Central bankers stand accused of reacting too slowly to signs that the inflation crisis is dissipating, less than two years after they were criticised for being late in responding to the most brutal surge in prices for a generation.

Some policymakers are already warning that by waiting too long to cut borrowing costs, central banks could harm weakening economies — the eurozone has stagnated all year — or hobble heavily indebted governments such as Italy.

The European Central Bank was thrust into the forefront of this debate this week after eurozone inflation fell to 2.4 per cent, its lowest level since July 2021, taking price growth tantalisingly close to the bank’s 2 per cent target. Similar debates are brewing in the US and UK, even if headline inflation rates there have not yet fallen as low. 

“The question is which of the big central banks are at risk of making a policy mistake here, and to me, it is most likely the ECB, because inflation will fall back quickly,” said Innes McFee, chief global economist at Oxford Economics. “They have every incentive to talk tough, but the action is going to have to change.” 

Investors reacted to this week’s third consecutive month of below-forecast eurozone inflation data by bringing forward their bets on how soon the ECB will start cutting interest rates; many economists now expect this in the first half of next year. 

Dirk Schumacher, a former ECB economist working for French bank Natixis, said eurozone inflation was on track to hit 2 per cent by next spring. But policymakers’ fear of underestimating inflation again meant “it will take a bit longer to reach a sufficient consensus in the governing council for cutting”.

He predicted the ECB would cut rates in June and then proceed at a quarter-point cut at every meeting next year.

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Italy’s new central bank governor Fabio Panetta, who joined from the ECB last month, hinted this week that rates might need to be cut soon “to avoid unnecessary damage to economic activity and risks to financial stability”.

Sovereign bond markets rallied after comments by Banque de France governor François Villeroy de Galhau, with investors adding to their bets on a rate cut by the ECB in the first few months of next year.

“The question of a cut may arise when the time comes during 2024, but not now: when a remedy is effective, you have to be patient enough on its duration,” he said.

But other rate-setters are pushing back. Germany’s central bank boss Joachim Nagel said this week’s “encouraging” fall in inflation was not enough to rule out the potential that borrowing costs might need to go even higher. He also warned it was “far too early to even think about a possible reduction in key interest rates”.

That argument received support from the OECD this week, as chief economist Clare Lombardelli argued the ECB and Bank of England would not be in a position to ease borrowing costs until 2025 given persistent underlying inflation from wage pressures.

Central bankers are also well aware that a backdrop of slowing demand, rising unemployment and continued pain for mortgage holders will fuel political pressure for rates to be eased.

That is particularly the case given the UK is heading into a likely election year. Huw Pill, BoE chief economist, told the Financial Times last month that falling headline prices could give a false impression that the inflation threat had passed.

The challenge for policymakers, he said, was ensuring there was enough “persistence” in keeping monetary policy tight at a time when there would be “lots of pressure in the face of weaker employment and activity growth and declining headline inflation, to declare victory and move on”.

Fed chair Jay Powell
Fed chair Jay Powell: ‘We are prepared to tighten policy further if it becomes appropriate to do so’ © Kevin Lamarque/Reuters

In the US, where growth has remained much stronger than in Europe, the Federal Reserve has barely wavered in its stance that its rate-raising cycle may not be over and those expecting relief in the form of cuts will need to be patient.

“It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so,” Powell said on Friday ahead of a scheduled quiet period before the final policy meeting of the year in mid-December.

This hesitancy reflects a desire by the Fed to safeguard its credibility by avoiding the need to reverse course if price pressures remain stubbornly high, a danger Mary Daly, president of the San Francisco Fed, highlighted to the FT in November.

Ian Shepherdson, chief economist at Pantheon Economics, said another reason for the Fed’s “extended hawkishness” was its worry about again misjudging inflation’s trajectory, having been widely criticised for failing to anticipate the post-pandemic surge in prices.

But with economic activity set to slow, labour demand softening and wage growth moderating, Shepherdson said the Fed was now flirting with a different kind of forecasting failure — underestimating the pace of disinflation.

“The pressure is going to ratchet up over the next few months, which is why I’m sticking to my March rate cut [forecast],” he said. Over the course of next year he expects the Fed to slash its policy rate of 5.25 to 5.5 per cent by 1.5 percentage points, and by another 1.25 percentage points in 2025.

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Yet some policymakers say it is still too early to declare victory in the battle against inflation, while in the US, there is a risk that recent rapid growth could keep inflation too high. William English, a former director of the Fed’s division of monetary affairs, said that in this scenario, the Fed would not be deterred from keeping interest rates elevated even if political goading intensified ahead of next year’s presidential election.

“That’s the whole point of having an independent central bank, and they really don’t want to screw that up,” he said. 

ECB president Christine Lagarde this week warned that eurozone inflation was likely to surge again in December as government subsidies, which have kept energy prices low, are removed.

In the eurozone, much of the debate now hinges on core inflation, which strips out volatile energy and food prices. Economists say annualising the past three months of core inflation shows it has already fallen to the ECB’s target. But others point to one-off factors dragging down inflation — such as falling package holiday prices — and say rapid wage growth will keep it elevated through next year.

“The public pressure on the ECB will rise, especially from the highly indebted member countries,” said Jörg Krämer, chief economist at German lender Commerzbank. “However, the ECB should resist the pressure,” he said, predicting eurozone core inflation would stabilise at about 3 per cent next year.


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