The year 2022 will indisputably be dominated by inflation and the reaction of the central banks in the form of interest rate hikes. Those interest rate hikes have not been very good for the prices of financial assets, but the end is gradually in sight. Step by step we are moving towards the most interesting period of the cycle.
The most interesting period
This is the most interesting period of the cycle, because there is also increasing disagreement within the central banks about the approach. Ultimately, interest rate hikes are a severe constraint on the economy, which could lead the economy into a severe recession. The trick is therefore to tackle inflation without doing too much damage to the economy.
In the United Kingdom, for example, there was already considerable division within the Bank of England (BoE) over the latest interest rate hike of 0.50 percent. The increase brought the interest rate in the United Kingdom to 3.5 percent, a level it last reached in 2008. Interestingly, two central bank members, Tenreyro and Dhingra, voted ‘no’ to the rate hike.
They believe that interest rates should have remained at 3 percent, because they are afraid that this new interest rate hike will hurt the economy. Furthermore, 6 members of the BoE voted for the interest rate increase of 0.50 percent and 1 member was even in favor of an increase of 0.75 percent. We are slowly but surely getting to a point where it is becoming more difficult to make the strategy for central banks.
Sticky inflation
What makes the story even more difficult for central banks is that inflation is a lot stickier than hoped. This means that interest rate hikes will not simply cause inflation to disappear. For 2023, for example, the European Central Bank expects the consumer price index to remain at 6.3 percent, compared to 5.5 percent before. After that, this important number will only drop to 3.4 percent in 2024, while they had previously bet on 2.3 percent.
The bizarre thing is that they even expect inflation to be above their target in the year 2025, despite the aggressive attitude. The European Central Bank also raised interest rates this week by 0.50 percent to 2.50 percent. If we are to believe President Christine Lagarde, then the ECB is not done with that either. It looks like they’re willing to go through a recession to bring inflation down to 2 percent.
