Simon French: Central banks must argue the case for short-term pain and long-term gain

This week both the US Federal Reserve and the Bank of England will raise their interest rates. That this statement does not require any caveat is an extraordinary break from events of the last decade. Financial markets have become conditioned to gradual and cautious shifts in monetary policy since the Global Financial Crisis. This year the debate has shifted from whether interest rates have to rise, to how much they will go up by. This pivot has become necessary because inflation is threatening to hit double-digits across much of the world. These are levels not widely seen since the early 1980s. Whilst the risk that such price increases repeat year-in, year-out is low – it is a risk that no longer justifies the exceptionally supportive monetary stances adopted by Central Banks during the pandemic.  

It remains to be seen whether Central Bankers can stand behind unpopular short-term decisions to justify their longer-term objectives. This separation of policymaking from political pressure was of course the intellectual justification for Central Bank independence in the first place. This policy independence – in the Bank of England’s case granted almost twenty-five years ago – now faces what may be its sternest test. Telling the British public that slower economic growth today is a price worth paying for lower inflation tomorrow is not a message that will win Bank of England Governor, Andrew Bailey, many friends. The UK is not alone in the heightened politicisation of interest rate decisions and inflation. Ahead of the US midterm elections in November, high gasoline prices, rising mortgage rates and a punishingly strong US Dollar are all going to be seized on by Republicans looking to take back control of the US legislature. In the Eurozone, where interest rates have not risen since 2011, higher interest rates have the potential to renew economic and political stresses in more indebted, slower-growing bloc countries. The amount the Italian government pays for its 10-year debt compared to the German government has increased by 0.5% since the start of the year. If the European Central Bank stops buying additional government debt in July – as is now widely expected – this gap will widen further.     

Make no mistake, these are uncomfortably political decisions facing Central Banks. Deflating internal demand in their domestic economies to avoid high energy and food cost inflation from spreading is controversial. Previous episodes of inflation over the last twenty-five years have largely been at a time of weak employment, acute political uncertainty, or both. Central Banks could ‘look through’ these episodes without raising interest rates and keep their political masters happy. This was aided and abetted by smooth-functioning global supply chains, particularly from China, that kept bringing prices back under control.  Even before recent lockdowns in the China these supply chains were under strain as COVID, and a more Sinosceptic approach to trade, raised prices.

The impact of this next phase of the COVID recovery – dealing with the inflation fallout – has already rattled global stock markets. The US stock market, the biggest beneficiary of low interest rates, has just had its worst April in fifty-two years. Huge and highly valued technology companies like Netflix and Facebook – that are almost certainly part of your pension savings – have fallen sharply on fears consumers are going to be hit from multiple angles. Small comfort for UK investors can be found in the fact our own stock market has been one of the best performers this year. Lowly-valued, but big dividend paying companies in the mining, energy and insurance sector have offered a safe-haven. For a stock market that has been on the naughty step since the 2016 Brexit referendum this rotation in investor appetite is long overdue. However even this revival would struggle to survive an interest rate-driven recession.

So Central Banks are now tasked to deliver a tough message. The options to bring inflation back under control will neither be popular, nor will they be without criticism. The argument will be that they are necessary. That work starts in earnest this week.

Simon French

Managing Director, Head of Research