The central question that policymakers need to answer is this: Will higher energy prices drive up core inflation? That is what will determine whether they can “look through” the Middle East crisis or not.
Evidently, one big concern among officials is that the higher prices go, and the longer they stay high, the more likely it is that the inflationary impact snowballs. The relationship between energy prices and areas like food and services inflation is not necessarily linear.
Firms can weather short-term price fluctuations in their margins, but not forever. And the higher inflation goes through the second half of the year, the greater the impact on next year’s annual price resets. Think of your internet or phone bills, for instance, that might explicitly be indexed to prior rates of inflation. Something similar is true of collective bargaining discussions in Europe.
That kind of thing risks making the whole inflationary episode longer-lasting – and if you listen to Bank of England Chief Economist Huw Pill, we’re probably close to the inflection point. He’s previously argued that when inflation hits 4%, it’s statistically much more likely to stay high for a prolonged period. And by my reckoning, if energy prices are sustained at today’s levels (a big if), it just about gets us there.
That’s the fear, anyway. Personally, I just don’t buy it.
Central banks are concerned about rising inflation expectations. And rise, they will. Ask any consumer where they think inflation is going, when they can see their petrol prices rising, and surprise! They will tell you it is going up.
But that makes no difference whatsoever if consumers (and businesses, for that matter) can’t act on that information. In an environment where vacancy rates are dramatically lower than when the last energy shock hit, workers simply don’t have the same power to seek faster pay rises. Nor, in many cases, do companies possess the power to materially pass on higher energy costs, either.
If that’s the case, then those firms are much more likely to deal with higher costs by cutting staff. And remember, the whole “non-linear” argument applies just as much to the jobs market as it does inflation. Job losses, once they begin at scale, have a habit of spiralling as economic demand weakens across the economy.
Something similar is true in financial markets: the higher energy prices and interest rate expectations go, the greater the risk that something breaks. And when that happens, the ripple effects can often be felt far and wide.
Central banks are naturally well aware of this – and said as much this week. The BoE, for instance, said explicitly that higher energy prices could necessitate rate cuts if the fallout is primarily through the jobs market.
Still, that won’t stop central banks talking up the possibility of rate hikes over the coming days, in the hope words can do some of the work for them. Some of this is directed squarely at governments. ECB President Lagarde explicitly warned them to keep energy support “temporary, targeted and tailored”. The message is clear: government support, of the likes we saw in 2022, will build the case for rate hikes. Spain is the first out of the traps today with VAT cuts on electricity bills.
Regardless of that, there may come a point, if this crisis worsens, where central banks feel they have no choice but to preserve their inflation-fighting credentials and tighten policy.
In our team’s more extreme energy price scenario, where oil averages 120 USD/bbl in Q2, we’d expect the ECB to hike twice this year. The same is probably true of the BoE. Markets are certainly right about one thing: if the central banks do raise rates, they are unlikely to do so only once.
But it’s a risky strategy. Central banks rightly need to avoid a re-run of the previous inflation overshoot. But in doing so, they risk fighting the last battle.
It’s one thing to talk about rate hikes, quite another to deliver them. They are not our base case for the Fed, ECB or BoE just yet.
Ultimately, this is not 2022. The economy looks markedly different. And rate hikes may only compound the economic challenges coming down the track.
James Smith