In a big week for monetary policy, the US Federal Reserve and Bank of England are under pressure to show they are serious about tackling stubbornly high inflation. Last week’s US inflation figure for August of 8.3 per cent — above expectations and still near 40-year highs — spooked the financial markets. A slight fall to 9.9 per cent in the UK in August was also hardly cause for celebration. While both central banks have been rapidly raising interest rates this year to rein back demand, this week they will set policy amid an increasingly frail growth outlook. Increasing the cost of credit further will hurt already ailing households and businesses, but both central banks will need to hold firm.
In America, a drop in price growth over the summer from a 9.1 per cent peak in June had generated some optimism. News of easing global supply chain pressures and high retail inventories gave hope that price growth would be tamed quickly. But the case for the Fed to go slower on rate increases at its meeting on Wednesday, after its 75 basis point increase in July, has not strengthened. Core inflation — which strips out volatile items like energy and food — pushed higher last month and shows the US economy is still overheating. The labour market remains resilient too, with high demand for workers sustaining upwards pressure on wages.
The US has however been relatively less affected by the energy inflation ravaging Europe. In Britain, the government’s recent plan to cap energy bills for households and businesses, with more details of the latter due to be unveiled on Wednesday, should help to lower near-term inflation. But the package — estimated to cost around £150bn — risks keeping demand and inflation higher over the medium term. This boosts the case for the Bank of England to continue to decisively raise rates on Thursday. Indeed, further stimulus, in the form of tax cuts expected to be unveiled at Friday’s “mini-Budget”, will give a jolt to spending too.
Wage pressures also remain firm in the UK: unemployment has fallen to its lowest rate since 1974, while high levels of inactivity continue to strain the labour supply. Indeed, at 5.5 per cent, wage growth remains inconsistent with the BoE’s 2 per cent inflation target. The collapse of sterling to a 37-year low last week against the dollar, which adds imported price pressures, also means the BoE will need to be wary of falling too far behind the Fed.
The challenge for both central banks is raising rates while recession risks remain strong. While the US economy has shown some resilience, business activity has been losing momentum. In the UK, the energy package will cushion the impact of surging energy prices, but many will still face a testing winter. Global headwinds from Europe’s energy crisis and China’s ongoing Covid-19 lockdowns will also damp growth prospects in the months ahead. Higher interest rates will only add to the pain.
Yet the risk of high inflation becoming entrenched is the greater danger. The longer it stays elevated the greater the damage it will do to households and businesses. While inflation expectations have fallen recently, US consumers still expect it to be over twice the Fed’s target in a year’s time. Many will be looking for officials’ interest rate projections to signal a robust monetary policy for the rest of 2022 and potentially into 2023. Meanwhile, in the UK, public satisfaction with the BoE’s handling of inflation recently fell to its lowest on record.
Both central banks need to bolster their credibility, after falling behind the curve on inflation. Acting firmly and quickly now will be important — especially as the damping growth outlook may make rate rises harder to pull off in the near future.