Inflation isn’t dying quietly. The International Monetary Fund has called it a “twin peak” problem. We may be over the first peak, but argument is now hotting up about the second: how best to find our way over that to the old near-zero inflation world. It’s a tangle of four overlapping points of view, held by optimists and pessimists, hawks and doves. 

 “Headline” inflation - the annualised rate of change in consumer prices - has peaked in most parts of the world. In all major economies except the UK and Italy, it was back in single figures by January, and even those two were still only a notch above. The drop in wholesale energy prices (helped by a mild start to winter), and the easing of (most) supply chains, had brought the headline figure down to 6.4 per cent in the US. And forecasters were looking forward to continued declines through the year. When we’ve had to live with double figures, forecasts of 3-4 per cent by the end of 2023 looked pretty cheering.

But that’s only the first peak. Central banks still face the question: how much farther do they need to raise rates to get us safely over the second peak, in “core” inflation? And - more difficult still - when can they publicly declare victory by starting to cut?

“Core” inflation is the domestically-generated kind. Pessimists fear this may persist at levels still uncomfortably above the targets adopted by most major central banks. Against those targets - more or less 2 per cent - inflation at 3-4 per cent still looks like a problem. Rather, it does if there’s a risk it may stick there (or bump up again). Is that risk the same for all governments, or will some find it harder to deal with than others?

Financial markets have until very recently been more or less in the optimists’ camp. The central expectation was that rapidly-declining inflation would be matched by an almost equally rapid reversal of interest-rate rises. Central banks would stop worrying about overshooting targets, as their forecasts suggested they would soon be undershooting. A drop in interest rates, so this story went, would boost the recovery, so stock markets stayed quite perky, too. Recovery would help pay for wage rises without risking more inflation. It was going to turn out Just Right, and quite soon too.

This storybook - sub-title, Goldilocks - depended on the belief that the modern, flexible, free-trading global economy could digest a bulge in energy prices with little more than a “transitory” bout of inflationary indigestion. It was just taking a little longer to do that than central bankers had originally supposed - and that was excusable, because they didn’t expect a war in Ukraine.

So those market hawks who became fidgety when central banks were slow to raise interest rates had subsequently become doves. As the headline inflation numbers started to drop, bond markets rallied strongly.

These optimists were joined by a bunch of economists unfashionably focused on the money supply. It’s hard to place too much faith in those who follow the money supply mechanically, because that never worked well even in the heyday of monetarism. And in a digital age the money supply has become ever harder to define (let alone measure) accurately. But this group had a beguiling argument. They argue that this time the theory is working: growth in the money supply was sounding inflationary warnings well before central banks got wise; and the contraction in broad money was now equally validly telling them to ease off. In their playbook, monetary policy has done its job and can rapidly be put into reverse. 

But these are now matched by the growing band of pessimists. They fear that inflation is becoming more deeply embedded, in most economies, than was originally hoped. The general problem is that as an inflationary shock from energy and raw materials works through economies to their “core”, it moves from markets that behave like yo-yos to ones that are more like ratchets. In those markets, monetary policy may slow price rises but doesn’t switch them into reverse. That’s not true of all domestic markets, of course: residential property responds to monetary policy like a kick in the teeth, and house prices are now dropping worldwide.

But labour markets are famously “sticky downwards”. Wages rarely drop in nominal terms, and if they have fallen (to varying degrees) in real terms in 2022, it’s far from certain they will do so in 2023. The suspicion that the inflation battle might not be over has penetrated financial markets, and bond markets have reversed.

It’s a fear fuelled by different factors in different parts of the world. In the US, it’s been the strength of the recovery from Covid, fuelled by a big fiscal boost. Good output news has been seen as bad by the pessimists, because it came before the Federal Reserve got a grip on inflation, rather than after. The labour market hotted up, and even if inflation slowed a little, recent data have been consistently more inflationary than expected. The US started from a much better position than most, with less pressure from energy prices and a strong dollar; but even here the Goldilocks story is looking a bit less credible.

A former famous US central banker used to say that you had to hit the American economy with two bricks to stop it coming; the trouble is, that leaves a lot of bruises. It’s why the Federal Reserve has found it so hard to achieve “soft landings”. America’s current central bankers are clearly trying to use expectations to reduce their dependence on the brick pile. So while they have begun to taper-off rate increases, they have continued to insist they will do whatever it takes to get back to the inflation target. The conflict has begun to reawaken fear in the markets that instead of everything looking Just Right, it might all end up Just Wrong.

In the European Union, fear is fuelled by the risk of tensions between northern hawks and southern doves.  Post-Covid recovery in Europe suffered the worst shock from war in the Ukraine. The Euro area’s powerhouse, Germany, was dependent on Russian energy (and also took a battering from stop-starts in China). So the European Central Bank was cautiously late into the rate rise game.

But inflation has stayed disappointingly high, bouncing back in Germany to 8.7 per cent when fuel subsidies were cut (or over 9 per cent on the “EU-harmonised” index). German central bankers are amongst those most openly worrying about “core inflation”; the President of the Bundesbank has called it “stubborn.” So for the moment, he and his fellow hawks are calling the shots. While the Federal Reserve made only a quarter-point move in January, the ECB added another half. 

Of all major economies, Germany is least likely to tolerate a softening of counter-inflationary ambitions. Bond sales are under way by the ECB, and now the markets are looking for another half-point rate rise in May. Squeezing inflation out of the entire Eurozone may, however, severely increase tensions between its different regions.

In the UK, fear is fuelled by a mixture of ancient history and modern shocks. Pessimists hark back to the 1980s, when (really!) high interest rates brought headline inflation down, but the rate of increase in earnings never dropped below 7% throughout the entire decade. That fed a rebound in inflation and the battle against it had to be fought all over again in the 1990s. Who says it will different this time?

Well, the optimists have some reason to do so. There is less union power and more variable pay in the mix today than there was forty years ago. Variable pay is not common (or even appropriate) in much of the public sector, but if private-sector pay subsides it will take some pressure off policymakers.

But then there are the new headwinds. If all major economies are suffering from similar tensions, those with tight labour markets and/or slow growth in productivity have the least room for manoeuvre. They face the greatest pressure on wages, and/or are least able to finance higher pay. And the UK has suffered two shocks to its productive capacity: the loss of free movement of labour from Europe following Brexit and the exit of some half a million over-50s from the labour force following Covid.

This combination tightened the post-Covid labour market, to a degree the Bank of England now admits it didn’t expect. Add to that a fiscal episode that freaked the financial markets and battered sterling, and the UK entry into this next phase of economic readjustment looked peculiarly torrid, with recession both inevitable and necessary.

It things could hardly have looked worse, it’s fair to say they do now look a bit better. There’s greater fiscal control, rebuilding confidence with the markets. The over-50s have been coming back into the labour market, as their Covid fears receded, their health improved or their furlough savings finally ran out. A net 200,000 people became “economically active” again in the last quarter. Immigration also surged in 2022. So the Bank of England forecasts that the finger on its economic dial will move from excess demand to excess supply during the second quarter of this year, with no more than a “technical” recession.  

Even so, unemployment is still well below the levels that - up to only a decade ago - were deemed to be the lowest on which the economy could run without overheating. So German-style worries about “core inflation” feature strongly in the Bank of England’s February monetary report, too. This calls out wage pressures and prices in the services sector, both stronger than the Bank was forecasting as recently as last November.

Hence the growing conviction that before changing course, central bankers in all the major economies will demand hard evidence of a decline in core inflation. Forecasts of a plunging headline rate won’t be enough to spin the wheel. Moreover, even when central banks dare to stop increasing rates, the pessimists’ point out that starting to cut is a very big call. Central bankers won’t want make it until they are sure they will not have to put rates up again. And the risks of sticking your neck out are greater outside the United States, when a false early move might earn payback in the foreign exchange markets. But to put an optimistic shine on this, a bit of hesitation would be no bad thing. In the long term, negative (or even very low) real interest rates aren’t good for anyone. The trouble is, a run of such low rates has created a large cohort of vulnerable people who assumed that money would be more-or-less free for ever.

So much will hang on the outcome in the US - and on how the new pay round starts in various different economies. Will wages still be catching up, or responding to a falling inflation headline? The more the second peak of “core” inflation looks like a plateau, rather than a molehill, the more difficult it will be for central bankers to maintain the credibility of monetary targets if they actively start to cut rates.

In the end, of course, the politicians will call the shots. When the British Prime Minister started 2023 by pledging to halve inflation in a year, he was instantly criticised by the Opposition for a lack of ambition. After all, at the time, the Bank of England was forecasting that inflation would be down nearly two-thirds by the end of the year. It all looked rather easy.

Seven weeks later, however, when the Leader of the Opposition made his own rival pledges, he made no pledge on inflation at all. Is he in the optimists’ camp, and thinks that story’s over? Or has he joined the pessimists, and fears it will all look rather murkier in a year’s time, when he is on the runway to a general election?

Guest Author: Baroness Sarah Hogg, Former Frontier Economics Chairman