Why do interest rate hikes not control inflation?

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Central banks have raised interest rates at the fastest pace since the 1990s, but the most severe inflationary spurt in a generation has yet to be brought under control.

While many were slow to see how much of a problem this wave of inflation would be, officials representing the world’s 20 largest economies have now hiked rates by an average of 3.5 percentage points each since they began. to tighten borrowing costs.

However, neither Federal Reserve Chairman Jay Powell nor European Central Bank President Christine Lagarde expects inflation to return to its common 2% target before the start of 2025. So As major consumer indices have fallen, central bankers cite higher core inflation, tight labor markets and pressures in the service sector as evidence that prices will continue to soar for some time to come.

So what explains the persistence of inflation in the face of aggressive rate hikes?

More late than usual

Monetary policy always comes with a lag, it takes about 18 months for the impact of a single rate increase to fully pass through to spending habits and prices.

Monetary policymakers started raising rates less than a year and a half ago in the United States and the United Kingdom, and less than a year ago in the euro zone. They went above the neutral rate – where they actively restrain the economy – only a few months ago.

But some central bankers and economists think the lags could be even longer – and the effect of the tightening less powerful – this time around.

“Maybe monetary policy is not as strong as it was decades ago,” said Nathan Sheets, chief economist at US bank Citi.

They argue that, despite soaring borrowing costs, growth has proven surprisingly resilient, especially in the services sector which constitutes the bulk of economic output in most economies. “Major economies and the global economy as a whole have absorbed rate hikes extraordinarily and surprisingly well,” Sheets said.

A long-term shift from manufacturing to services, which require less capital, could also mean a slower transmission of tighter monetary policy.

Structural changes in large parts of the economy – including the housing and labor markets – between now and the 1990s may explain why rate hikes have had a much sharper and more marked impact in the ‘era.

Housing trends play a role

Changes in the housing market may be the key to why interest rate hikes are taking longer to bite.

In several countries, the proportion of households that are either freehold owners or tenants has increased. Fixed-rate mortgages are now more popular than flexible loans, where higher central bank rates affect household purchasing power almost instantly.

In the UK, the share of UK households owning a property with a mortgage has fallen from 40% in the 1990s to less than 30%. Those with variable rate mortgages have fallen from 70% in 2011 to just over 10% this year.

Andrew Bailey, Governor of the Bank of England, said last week that these trends meant that “monetary policy transmission is going to be slower as a result.”

Labor markets are tight

The aftermath of the pandemic on hiring trends is still being felt.

Widespread labor shortages remain, particularly in the service sector, which is boosting wage growth and hence inflation.

Lagarde said last week that companies in the service sector could engage in “labour hoarding”, fearing they could not hire if growth strengthened. The sector could be “insulated from the effects of policy tightening for longer than in the past”, the ECB President said.

The central bankers’ puzzle

The initial insistence by central bankers that inflation would be short-lived delayed the abandonment of decades of aggressive and ultra-loose monetary policy.

These delays may have made inflation all the more difficult to beat with higher rates, as price pressures shifted from a problem affecting a small number of commodities hit by bottlenecks in the supply chain to a much broader phenomenon, affecting almost all goods and services.

The Bank for International Settlements, often dubbed the central bankers’ bank, warned last year that if interest rates were raised too little or their effect was long delayed, countries could slip into an environment of high inflation. would become the norm.

The risk is that a return to 2% inflation will force central bankers to raise borrowing costs to such an extent that they endanger the health of the financial system.

The collapse of several mid-sized US lenders and the problems at Credit Suisse earlier this year have been blamed on rising borrowing costs.

If growth also fades, economists expect more pressure on central bankers tasked with trying to get inflation under control.

Jennifer McKeown, chief global economist at Capital Economics, now expects higher rates “to push most advanced economies into recession in the coming months.”