The US Federal Reserve Board is pulling back on its major programme of support for the US economy. The Bank of England did not increase interest rates at its meeting on Thursday but is expected to move soon. The European Central Bank is holding out – trying to persuade investors that it will not increase its key interest rate next year, despite soaring inflation.
As economies bounce back following the removal of restrictions, central banks are confronted with a big conundrum – can they move policy, including interest rates, back to something which might be considered “normal”, without damaging economic recovery or leading to a big collapse in markets? The answer to this is one of the fundamental economic questions now facing – with big implications for borrowers, savers, investors and governments.
1. Why the change?
Central banks were, in many ways, the economic heroes of the pandemic. By pumping vast amounts of cash into the world economy they allowed governments to borrow and support their economies and populations through the massive Covid shock. But now they face a dilemma: inflationary pressures are evident everywhere and while central banks feel much of this is transitory, as we exit the restrictions phase of the pandemic, nobody is sure. We have, after all, never been here before. If they move too quickly they could upset the markets and destroy the recovery – if they move too slowly then inflation could become a “ thing” gain.
The bounce in economic growth and prices has pushed some central banks to act. The US Fed, whose goal is to support employment and hold inflation around 2 per cent, announced this week that it would scale back is massive programme of purchases of Government and other bonds. This will go from $120 billion (€104 billion) a month now to zero, possibly by next June. Investors are starting to bet on when the Fed will increase interest rates. The markets are betting on rate increases in the second half of next year, but Fed chair Jay Powell has said it is too early yet to speculate on this.
With inflation in the UK at 3 per cent and heading to 4 per cent or higher , the Bank of England did not raise interest rates at its latest meeting, but could do so as early as next month.
Only the ECB is really holding out. Financial markets have been in a bit of a joust with the ECB over the past week, with markets pricing in a small increases in the ECB's deposit rate by the end of next year, but the bank's president Christine Lagarde saying in a speech this week that the ECB was " very unlikely" to raise rates in 2022.
But while central banks are crossing their fingers and saying they believe inflationary pressures will pass, the different tactics they are employing underline the fact that nobody really knows what is going to happen.
2. The inflation dilemma
Prices are rising on average – but most of the damage is coming in a few areas. Energy prices are the most obvious. Then there are the supply chain problems gumming up deliveries and causing shortages – and feeding through to prices.
"Demand in the world economy has bounced back much more quickly from the pandemic than supply," said Simon Barry, chief economist at Ulster Bank in Dublin. The resulting shortage has also pushed up prices. The ECB is betting that the energy price pressures ease – there are signs that they might, says Barry, though a cold winter in the Northern hemisphere could maintain pressure – and that supply chains gradually recover in the months ahead. This would mean we are looking at once-off rises in prices, rather than a permanent increase in the rate of inflation.
If you look at the last Irish consumer price inflation figures you can see the argument. Of the 3.7 per cent rise in the inflation rate in the year to September, around 2.9 per cent was accounted for by rising transport costs and higher household costs. Both of these were largely due to higher fuel prices, though rising rents were also a factor in the household category.
Elsewhere increases in areas such as restaurants and hotels probably reflected in part reopening after the pandemic.Elsewhere – so far – price increases are generally modest or non-existent.
The danger would be if price pressures remained around long enough for people to believe that things have changed – and this would feed into wage demands, and thus a further round of more generalised price increases. In the jargon, inflationary expectations would change.
A more generalised return of inflation would create a dilemma for central banks, particularly if growth did not remain strong. In the euro zone the annual rate is now over 4 per cent, but the ECB still expect it to fall back to around 1.6 per cent in the medium term, below its 2 per cent target. An additional layer of difficulty is that inflation is currently driven more by factors pushing up costs than by demand, even though the latter is a factor too. Higher interest rates affect demand, but not supply.
3. Where next?
For now, expectations for interest rate increases are modest. The markets are tussling with the ECB over whether there might be a small increase in the rate it pays banks to deposit cash overnight – but as this is now minus 0.5 per cent, even if there was a 0.25 of a point rise next year it would still probably leave it in negative territory.
The refinancing rate, currently zero per cent, is the one which consumer charges are priced off; any increase here would probably be later and those on tracker mortgage rates would not be hit until then. Right now, the market sees ECB rates only edging slightly higher – by around 0.75 per cent – over the next four or five years.
The Bank of England is expressing more concern about inflation. At the moment the markets expect the UK base rate to increase to around 1.1 - 1.25 per cent by the end of next year. They are also pricing in two Fed rate rises next year.
There are a few points to note here. One is that expectations in the markets can change quickly – investors are as confused as the rest of us about what happens next. The other is that there has been a general downward trend in interest rates since the 1980s – meaning rates have peaked at lower levels through each cycle .
And having fallen in the financial crisis, ECB rates have remained low for years. Economists also believe that, as well as low growth and sluggish inflation, longer term factor may be playing a role here, particularly ageing populations which require less of an interest rate incentive to save, because older people generally save more anyway.
A permanent return of inflation would change one key part of this picture. A key measure is real interest rates, which means how interest rates compare to inflation. Stable prices – and very little inflation – have helped keep interest rates down in recent years, but a sustained rise in inflation would put pressure on central banks to move their headline interest rates higher, as they considered the real interest rate level.
4. How will this affect you?
This changing picture has implications for personal finances which go way beyond mortgage and savings rates. For mortgage holders the hope is that rates will remain low, even if they edge up a bit. For savers the concern is that a generalised rise in inflation would not be matched by higher deposit returns. But changing interest rate expectations will affect all investment markets – as they change the benchmark from which other riskier investments are judged.
So if financial markets are wrong to be betting on interest rates staying generally low, then there could be a big fall-out both there and in markets for real assets such as property. Tapering support is a really tricky issue for central banks and some analysts feel the realpolitik of the risk to markets and government finances will stay their hand from significant moves, even if inflation does pick up.The appropriate role for central banks is now an issue of debate in economic policy.
As a massive borrower, this is also vital for the Government. The interest rate on our ten-year bonds remains low, at about 0.2 per cent, but is 0.5 of a point higher compared to the negative rates which applied earlier in the year. A vital factor next year will be where bond interest rates – the price on new and refinanced borrowings – settle as the ECB starts to wind down the amount it is buying on the market.
With a ready buyer removed, investors will start to be more cautious and assess the finances of each State for risk . This will be a key moment in the exit from the pandemic. Ireland’s strategy has been to keep borrowing at a similar or lower rates than other EU countries – to keep “ in the pack” – so as not to attract attention as ECB support is wound down. But some rise in borrowing costs is likely – and nerves could rattle a bit in bond markets generally if fears grow that inflation may become embedded.