FLASH
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Chances are that by the time the trees leaf out in Washington, Frankfurt and London, the inflationary crisis of this decade will finally be over.
The storm has already passed and prices have increased at rates no higher than the central banks' targets in recent months.
In the six months between May and November last year, for example, the annual rate of consumer price inflation was just 0.6 percent in the UK and 2.7 percent in the eurozone.
Excluding volatile energy and food prices, annual core inflation rates were 2.4 percent in both economic zones over the same period.
In the US, the equivalent measure of the Federal Reserve's favored personal consumption expenditure deflator was just 1.9 percent with a total rate of 2 percent.
Therefore, all central banks need to do to bring inflation rates in line with their targets is to avoid a worsening of price controls in the US and Britain and correct a small improvement in the eurozone. If so, they can declare victory.
It goes without saying that the sharp fall in inflation on both sides of the Atlantic in the second half of 2023 was as surprising as its earlier rise.
Last summer, the Fed, the European Central Bank and the Bank of England expected inflation to stay above the earliest target until 2025.
While the improvement in the outlook has been welcome and remarkable, the legacy of the inflationary crisis will not end once prices rise again at normal rates. The evidence suggests that the public resented the cost-of-living hikes and arbitrary crackdowns of the past two years, and memories are likely to fade more slowly than inflation statistics. Politicians will have to give a better account of the sacrifices made by many people than simply telling people that living standards are rising because inflation is falling.
With interest rates rising from zero effective in 2021 to cap levels of 4 percent in the eurozone, 5.25 percent in Britain and 5.5 percent in the US, the battle over rates will also enter a new phase in 2024. The need to tighten policy is gone: the question for next year is how and when to ease the tightening.
To answer this question, we need to start by examining what has been surprising about the decline in inflation so far. Compared to expectations this time last year, the US, the eurozone and the UK all avoided the recession and rise in unemployment that most economists expected. Growth was significantly better in America than in Europe, but the supply side of economies on both sides of the Atlantic beat expectations. This suggests that central banks do not have to limit demand growth as much as they once thought.
Central bank officials generally agree they will cut interest rates in 2024, but are reluctant to move quickly for fear of financial market glut – and a residual risk that inflation will not be fully subdued.
There is a difficult trade-off here. It is necessary to wait some time before lowering interest rates, in order to ensure that the price trends of the last six months are not a false dawn. Wage growth should also moderate, although central bankers should allow for a temporary recovery in real wage levels to reflect both productivity gains and lower import prices that many countries benefited from in 2023.
But since monetary policy works with a delay, the longer the delay, the more costs are associated with waiting. Therefore, the Federal Reserve's first rate cut should occur in March, as financial markets expect. The ECB and the Bank of England would be wise to follow a similar timescale rather than stall, especially as Europe's economy is weaker and more prone to an unnecessary downturn. So far, officials on both sides of the Atlantic have been reluctant to suggest that such timely action is possible.
If financial markets are correct in suggesting the desirability of an early rate cut, they have gone too far in suggesting that interest rates will fall almost as quickly as they rose, leading to a 1.5 percentage point cut in both the US and also in the eurozone this year. Unemployment is low everywhere, there is little spare capacity, and so there is a risk that inflation will reignite if economies overheat.
Therefore, central banks would be wise to start easing quickly, but not to move too quickly unless economies appear to be heading for a deep recession. They must find a soft path towards relatively neutral interest rates so as not to stimulate or limit economic growth and inflation. This level is unknown but not necessarily much lower than the official rates prevailing today and certainly not close to zero.
This caution should apply even if inflation temporarily falls below zero in the coming months, for example if energy prices fall sharply. Lower import prices for consumers would allow for higher incomes and greater consumption and would not be a sign of impending economic collapse.
If the past few years have taught us anything, however, it's that expected scenarios are likely to be buffeted by events beyond policy's control. Therefore, the most important attribute for central bankers this year will be flexibility in the face of inevitable forecast errors and the ability to communicate the need for policy to adapt to changing circumstances. It is wonderful that high inflation has been defeated. The hard new world begins now./ Financial Times
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