A Monetary Policy Mistake May Be On The Horizon

Central banks across G10 may well be on the verge of making a significant policy mistake.

While this week’s bonanza of policy decisions, by and large, saw policymakers adopting a ‘wait and watch’ approach to the current highly fluid economic backdrop, those decisions – especially from the BoE and the ECB – brought with them rather worryingly hawkish rhetoric.

In many respects, spot inflation doesn’t matter as much as one might think it does – not from a policy perspective. We are all well aware that interest rates are a very blunt instrument, and that no matter where interest rates are set, they cannot influence global commodity prices, the surge in which is the main driver of the higher headline inflation that we are now certain to see in coming months.

What does matter, is the potential for ‘second-round’ effects. Namely, when a surge in inflation leads to price pressures becoming embedded within the economy, turning a one-off shock, into a longer lasting issue.

This is, importantly, where the global economy appears very different, in almost every respect, to where we were in 2022, at the time of the last significant energy price surge. Labour markets display a considerable degree of slack, with earnings growth running at broadly target-consistent levels; economic growth is, for the most part, anaemic at best; the majority of G10 central banks are running moderately restrictive monetary policy stances; and, a broad-based disinflationary process was well-established prior to conflict having broken out.

With all that in mind, and with longer-run inflation expectations well-anchored, the potential for higher energy prices to lead to a sustained rise in inflation appears much more minimal this time around, than it did four years ago. Furthermore, the rather parlous state of DM labour markets, and lacklustre momentum more broadly, particularly on this side of the Atlantic, means that the real risk here is one of a negative demand shock, if higher energy prices prove prolonged, leading to a broader economic slowdown.

For the time being, given the huge uncertainties associated with the duration of the Iran conflict, as well as its precise economic fallout, central banks adopting a ‘wait and see’ stance is the logical thing to do. However, raising the prospect of tightening policy, to counter what appears a low risk of inflation proving more prolonged, raises the likelihood that a policy mistake will be made. An overly-tight stance would not only significantly amplify downside growth risks, but also increase the possibility of undershooting inflation targets over the medium-run.

It’s often said that interest rates are akin to a hammer, and that when all one has is a hammer, every problem looks like a nail. Right now, central bankers would be wise to keep their hammer tucked safely away in the toolbox.