How US and Britain manage inflation

To put things into perspective, in the United States, the Consumer Price Index grew 7.9%, the fastest pace since 1980s while the Producer Price Index (PPI) increased by 10% in February. For the UK, the PPI jumped by 10% in March, and inflation surged 6.2% – the highest since 1991. This was probably a little taste of what is in store in the following months.

EARLIER in the year, global economic prospects were promising as more sectors in the economy gradually reopened, more people were vaccinated, and mobility restrictions eased with economic growth steadily picking up despite a surge in Omicron-related cases.

This presents an ideal situation for any central bank to readjust its accommodative policy after supporting the economy throughout the pandemic.

Last December, the Federal Open Market Committee (FOMC) was expecting the US economy to grow by 3.4% to 4.5% this year, an upward revision compared with the previous projection with personal consumption expenditure growth rate hovering around 2.2% to 3.0%, much higher than initial forecast of 2% to 2.5% and its mandated target of 2%.

The US labour market continued to tighten as the unemployment rate is expected to decline to around 3.4% to 3.7% by the end of 2022. For the Bank of England (BoE), it was expecting Britain’s economy to grow by 6.7%, and inflation to be at 2.9%. The labour market was also in a good shape, where unemployment declined to 4.5%.

Despite the promising economic recovery, inflation, which is a measurement of price changes for goods and services over the year, was running red hot as it grew at its multi-year fastest pace.

There were several reasons for this to happen.

First, the strong recovery in the labour market following the adverse effects of pandemic.

The second is related to cost-push factor. The economic recovery itself was a contributing factor, where demand significantly exceeded supply, thus creating shortages in the economy.

This is where we have been hearing repeatedly about supply chain disruptions.

In addition, different regulations in different countries may have prolonged the delivery lead time.

In the earlier assessment by both the FOMC and the BoE, both central banks believe that inflation will be transitory as factors that have been driving it were pandemic related.

This meant that inflation would stay relatively higher for a short period of time, before readjusting back to the long-term target of around 2%.

At the end of February, the world was shocked by Russia’s invasion of Ukraine. The market responded negatively to this event.

From its near peak earlier in the beginning of the year, the Dow Jones Industrial Index declined 11%, S&P 500 fell 13% and Nasdaq dropped 18%.

Across the Atlantic, the FTSE shed 7.2% and the British pound lost 1.7% during the week of the invasion.

As a fallout from the invasion, commodity prices surged, where Brent and WTI jumped by 59% and 60%, respectively.

Given the fact that Russia is a major exporter of fertilisers, an essential in food production, the Food Price Index soared 33% on an annualised basis.

The sudden spike in commodity prices impacted all parties, including traders, producers and consumers, exacerbating the already elevated consumer price level.

To put things into perspective, in the United States, the Consumer Price Index grew 7.9%, the fastest pace since 1980s while the Producer Price Index (PPI) increased by 10% in February.

For the UK, the PPI jumped by 10% in March, and inflation surged 6.2% – the highest since 1991. This was probably a little taste of what is in store in the following months.

There are two unwanted consequences from this event. First, both central banks now are facing a 70s to 80s deja vu.

Stagflation risk

As we are aware, both economies are at risk of falling into stagflation; a stagnant or contracting economy in parallel with high inflation, which contradicts the standard economic theory.

Second, if inflation is caused by demand-pull, it is easier for a central bank to fight inflation.

It can increase the policy rate, which will make cost of borrowing higher, thus dampening some demand. But what is unveiling currently is that inflation is very much due to a supply factor (i.e. cost-push factor). Therefore, the monetary policy will have zero or little impact in fighting inflation as it is out of central banks’ tools reach.

Adjusting interest rates

Nonetheless, both central banks are responding in their own way.

The BoE was the first to do so by adjusting its interest rates.

The first rate hike was made back in December 2021 to 0.25% from its record low, followed by a 25-basis points (bps) increase in February, just before the war and the latest rate hike was in March to 0.75%.

Some policymakers have said that they are open to another round of rate hike next month.

Furthermore, the reduction of the balance sheet or quantitative tightening (QT) will depend on the situation that the BoE could be facing. The central bank had said it would consider selling gilts once the 1% bank rate was reached.

The effects of rising interest rates on the current high inflation seemed to be muted according to data released in March. The inflation expectation in the UK wasn’t decreasing, which suggests that it is unlikely to recede anytime soon.

High inflation is also dampening growth prospects as it is raising the cost of living and eroding real income.

In addition, growth recovery was dampened. Some economists are expecting a recession by summer.

Aggressive approach

While the BoE took a gradual approach, the Fed was more aggressive.

The main reason for the aggressive approach has a lot to do with the Fed being behind the curve, meaning it was too late to shift its stance from dovish to hawkish.

Nonetheless, the Fed did eventually make its first move in normalising its policy by tapering its asset purchases back in November 2021 and eventually raising its federal funds rate for the first time since the pandemic started in March.

Further developments on prices continued to worsen, as evidenced by the latest inflation at 8.5% in March.

Several FOMC members, including the chair, are backing a 50-bps rate hike in the next meeting in May.

Some Fed members however, believed that the Fed should be even more aggressive in fighting inflation, backing a 75 bps rate hike.

The hawkish view has led to major outflows from emerging economies, including Malaysia, where the ringgit tumbled by 4.5% to the 4.36 level compared with early this year.

Despite calls for both central banks to be aggressive in tightening their monetary policy, we now are expecting the Fed to make a 50 bps rate hike for the next three consecutive meetings and a final 25 bps move by the last quarter of 2022.

On the BoE, we project one more 25-bps hike before pausing to reassess the domestic economic condition.

Adverse effect

The aggressive tightening could have an adverse effect on the economy.

Past experience suggested that it could push the economy off the cliff.

For example, in 2007 when the Fed tightened, the market crashed as the cost of lending skyrocketed.

The same situation is happening now. The dilemma for both of the FOMC and the BoE is how to strike a balance, without harming their economic recovery.For FX enquiries, please contact: [e-mail]

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