Central banks should sacrifice ambitions of a perfect economic landing

Evidence is mounting that many of the drivers of last year’s dramatic rise in inflation are dissipating. European gas prices are now at levels last seen before Russia’s invasion of Ukraine in late February. The cost of shipping a 40ft steel box from Shanghai to Long Beach has crashed from around $8,300 this time last year to $1,500. Used car prices have gone into reverse, even in the UK where they once commanded a higher value than new ones.

Does this mean less aggression from the world’s central banks in 2023? Not immediately. After pumping too much stimulus into the economy during the early days of the pandemic and then failing to spot the stickiness of the surge in prices until far too late, rate-setters will start the year as they ended it — desperate to restore credibility by talking tough about fighting inflation.

This hawkish rhetoric is not just about rebuilding trust. While headline inflation rates are tumbling as the base effects of last year’s sharp rise in energy and food prices fall out of indices, price pressures have not entirely faded.

Supply chain snags are no longer leading to surges in the price of goods, but trends in the services sector and labour market continue to trouble central banks. And then there is the lingering fear that the pandemic and flare-up of geopolitical tensions have left the global economy with less productive capacity than in 2019 — which, if true, would mean rate-setters would have to destroy demand to get inflation back down to the levels seen a few years ago.

Whether rate-setters will match their tough talk with bumper rate rises will depend on what the Federal Reserve does next. If 2022 taught us anything, it was that the Fed is the unseen hook upon which the decisions of the rest of the world’s rate-setters hang.

Central bankers did not collaborate formally in 2022. But they may as well have done. When Jay Powell started to raise interest rates last spring, the European Central Bank was still in wait-and-see mode and the Bank of England was plumping for the modest quarter point rate rises that central bankers (and their watchers) tend to favour. By the autumn, both the ECB and the BoE had followed the Fed’s lead and delivered jumbo rate rises of 0.75 percentage points of their own — a remarkable pace of tightening that shocked investors everywhere. By the end of the year, even the Bank of Japan had delivered its own hawkish surprise.

The US monetary guardian was able to bring the rest into line through the sheer might of the dollar. Central bankers are loath to admit to the pressure foreign exchange markets exert. But the extent of the slump of almost every major currency against the greenback — the euro was down by almost 16 per cent at one point in 2022, the pound by more than 20 per cent and the yen by almost a quarter — spooked them. Their response was to follow the Fed and supersize rate rises.

This year could be one of those rare occurrences when a weak US economy proves not dangerous, but a blessing for the rest of the world, should it ease pressure on Powell to raise rates. If the US central bank switches from half point to quarter point rate rises early next year, then it will give others the space to follow suit. The danger is that the US labour market continues to run hot and the Fed does not ease up. Others would again feel the need to match its firepower — despite their economies being in far weaker shape.

The big risk for 2023 is that rate-setters become so paranoid about losing face that they put their money where their mouth is and don’t just talk tough but impose multiple large rate rises. Rapid increases in borrowing costs would almost certainly push economies into recession. They could also spark bouts of financial turmoil that make the gilt market panic of last autumn look like a blip.

Turmoil would, as in the Bank of England’s case during the LDI panic, send mixed signals by forcing policymakers to prop up pockets of financial markets while trying to tighten credit conditions. Rate-setters would be exposed to even more political pressure — in Europe, French, Italian and Finnish leaders have already complained that the ECB’s attempts to rein in inflation are putting jobs and growth on the line, along with heightening the risk of another sovereign debt crisis.

Paying attention to threats other than inflation would probably make for fewer rate rises. That could, in turn, mean prices continue to rise by 3 or 4 per cent a year for the foreseeable future, and inflation’s descent stops short of the 2 per cent goal that rate-setters crave. That is not ideal. But, after a very messy 2022, sacrificing ambitions of a perfect landing for something more prosaic could prove the least worst option for everyone.

claire.jones@ft.com