How the World’s Central Banks Are Confronting the Inflation Conundrum

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Europe and Britain showed this week that inflation isn’t just a U.S. problem, and central banks are using different approaches to tackle it.

Prices increased by an annual 5% in December in the euro area, the European statistics institute said Thursday. And data from the U.K. the day before showed that inflation there had reached 5.4% the same month, the fastest pace since March, 1992.

Inflation in Europe is for now still running behind the U.S., where the consumer-price index jumped 7% in the course of last year. That reflects, in part, the particularly strong recovery and tight labor market in the U.S.

Central banks face a common problem with inflation, but diverge in their approach to tackle it. They are now admitting it won’t be “transitory” as expected a few months ago — to use the word officially retired late last year by Federal Reserve President Jerome Powell.

Central banks got two big factors wrong in underestimating inflation. They didn’t expect energy prices to rise as quickly this year as they did in 2021. And they forecast that supply-chain bottlenecks would subside within a few months, after the postpandemic surge in demand for goods fell back to a more traditional growth path.

But the year 2022 has begun with oil prices still on the way up. After jumping by more than 50% in the course of 2021, they are already up 12% since the beginning of this year. Meanwhile, in China the Omicron variant could lead to widespread factory closures if the government sticks to its zero-tolerance policy for the virus, triggering new bottleneck fears.

Equally alarming, so called core inflation — stripped of the effects of energy and food — is now also beginning to rise, as shown by the latest numbers.

And even though prices are “still being boosted by pandemic-related factors,” note analysts at

JPMorgan
,
labor markets that keep tightening “should keep inflation not just above prepandemic levels for most of the world but above many central banks’ inflation targets as well.”

Circumstances may vary from one region to another. For example, a hike of the value-added tax in Germany after rates were lowered during the pandemic will only have a temporary effect.

Britain, on the other hand, faces the perfect storm this spring, when a cap on energy bills for households will be raised, at the same time that the government is raising taxes to an unprecedented level. “It is almost a given that inflation will rise further come April” in the U.K., Investec economist Sandra Horsfield wrote.

Central banks aren’t in sync when reacting to inflation, because circumstances vary. The recovery is on and labor markets are healthy in the U.S., so the Fed feels it can raise its rates in March. Inflation is way above target in the U.K. and the unemployment rate is down to an all-time low of 4.1%, so the Bank of England raised rates last December and may do so again next month, according to

Bank of America

analysts.

As for the European Central Bank, it will stop its pandemic-focused asset buying program in March but is still adamant that circumstances are unlikely to justify raising its key rate this year, President Christine Lagarde reiterated in a radio interview Thursday. 

Lagarde remains confident that “inflation will stabilize and ease gradually in the course of 2022,” and the same view is shared for Britain by Bank of America, who expect “inflation to slow sharply” in the second half of the year and into 2023.

The ECB president said that the central bank stood ready to act if circumstances change, but added that it had “every reason not to act as rapidly and as brutally that one can imagine the Fed would do,” since the recovery cycle in Europe is lagging behind the U.S.

But even in Europe, wage growth is now bound to “significantly accelerate in 2022 and 2023,” according to ING analysts who note that the “stars align” to that effect, with labor shortages and increased minimum wages.

The rise of inflation and the diverging reactions of central banks raise two questions. The first is whether the central banks engaged in raising rates risk dampening a recovery already threatened by a few headwinds: Geopolitical risks (such as in Ukraine), or the Omicron variant, which has weakened business sentiment.

The second is whether central banks are equipped to tackle today’s kind of inflation. As Bank of England governor Andrew Bailey told the U.K. Parliament this week. Central banks, he cautioned, cannot for example lower the price of imported gas or ease supply bottlenecks.

Nor can they manufacture chips, or increase the number of workers looking for a job. 

Write to Pierre Briançon at [email protected]