These days, central bankers take the stage like army generals. They brag about their weapons and declare that they will destroy inflation, their long-standing foe. In the conflict, no quarter will be offered. The collateral damage will be significant.
The Bank of England will hike interest rates for the eighth time since last December, most likely to 2.25%, sending a signal to financial markets that Threadneedle Street is not done fighting inflation.
More rate hikes must be on the way, maybe to 3.5% or even 4% from today’s 1.75%, driving average mortgage rates to more than 6%.
After the consumer price index surged by 10.1% in July, most City experts predicted that the Bank would raise borrowing costs at its next meeting and continue to raise them into next year.
Meanwhile, Christine Lagarde, the head of the European Central Bank, stated on Thursday that “determined action had to be taken” following an unprecedented 0.75 basis point hike in the eurozone interest rate to 1.25%.
Such is his newfound confidence. Jerome Powell, the chairman of the US Federal Reserve, may as well have been dressed in army fatigues in his most recent public appearances. He assured central bankers last month in Jackson Hole, Wyoming, that the Fed would use its instruments “forcefully” until prices were under control.
Last Monday, he said that he would act “forthrightly and firmly,” adding, “We must stick at it until the work is done.”
Powell and Lagarde join the governor of the Bank of England, Andrew Bailey, in making a case for action based on the premise that higher interest rates can control current system inflation, which is driven primarily by rising energy costs and a spillover into higher transport and food prices.
Borrowing costs that are too high will also counteract so-called second-round effects, which result from workers’ requesting significant salary increases to compensate for the negative impact of inflation on living standards.
A lack of supporting evidence undermines these claims, leading to the conclusion that central bankers have been driven into macho posturing by politicians who want banks to have a hand while they sit on their hands, as well as by economic thought traditions.
According to economic theory, rising inflation encourages customers to spend more rather than risk holding cash that will be worth less in a year’s time. Higher borrowing rates dampen this desire.
However, recent studies suggest that customers understand that rising inflation is a very strong indicator of a shaky economy, and their response is to cut back on spending and build their savings. They may desire a new job and a raise, but worries about a recession cause them to remain in their current position and accept the wage increase offered.
According to the most recent S&P Global survey of the UK labor market, wage growth fell to its lowest level since March. Why is it March? because that was when employees believed the epidemic was finished and things were improving.
When we look at the nature of inflation, which is primarily imported, things get worse for central banks. The majority of the affected imports are necessities such as electricity and food. Because people and businesses must purchase energy and food, monetary policy has minimal influence on the quantities purchased.
Commodity scarcity is another factor driving up retail prices, but if it can be traced back to COVID-19 lockdowns in Chinese manufacturers, interest rate hikes in the UK will have little impact.
Catherine Mann, a former head economist at the US investment giant Citigroup, provides yet another justification for rate hikes. She claims that if the Fed and ECB continue to raise interest rates, the pound would fall to parity with the dollar.
Her thesis is that in a competitive market, money flows to where interest rates are greatest, which is the United States, where the base rate is already in the 2.25% to 2.5% range. She claims that a sinking pound invites more inflationary pressure, considering how heavily Britain relies on imports. So, unless the MPC moves decisively, it will be left behind, as will the pound.
However, this approach just serves to highlight that all central banks have lost the plot, hiking rates despite minimal evidence that it would have the desired impact. Low interest rates encourage rash speculation; in an ideal world, rates would be high enough to make financial institutions think twice before betting, mostly on real estate.
Low interest rates, on the other hand, are a lifeline in a crisis, especially when so many individuals and businesses have been pushed to pile up mountains of debt.
So, before awarding themselves a medal, central bankers should recognize that the instruments to reduce inflation are in the hands of others.
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