Inflation rates have been falling across the industrialised world, but fears that the Middle East war will raise oil prices means central banks are sitting on their hands when they should be raising interest rates to subdue inflationary pressures.
The US Federal Reserve, the Bank of England and the European Central Bank are still smarting from the criticism of their inaction in 2022 when inflation soared above 10% in the UK and eurozone, and over 9% in the US.
Central banks were plagued by accusations that they moved too slowly to confront inflation in the months after the Ukraine war started, when post-pandemic consumer spending was already stoking prices on everything from food to construction materials.
It's now been five years since they all met their 2% inflation target and now they are asking themselves whether the continuing blockade of the strait of Hormuz will mean a sixth or seventh year of target-busting prices growth?
The Federal Reserve seeks help
US inflation edged lower to 3.4% in July from 3.5% in June and 4.2% in May, largely in response to falling petrol prices.
Since the Bureau of Labor Statistics collected the data, the price of a barrel of Brent crude has risen again to about $90 – a figure that will push up the price of energy and transport across the US in the second half of the year.
Fed officials are asking whether US inflation will climb back towards 4%, double its target.
The US central bank's new boss, Kevin Warsh, has instigated an all-embracing review of the Fed's operations based on the advice of 15 outsiders that he says are among the most eminent experts and economists of the age.
Many analysts have applauded him for recognising that a series of inflation shocks dating back to the arrival of Covid-19 have undermined the integrity and durability of central bank forecasting.
Mohamed El-Erian, an economist and professor at the Wharton Business school, said Warsh recognised that many of the shibboleths of monetary policymaking had proved flawed.
“The key issue for me is having someone there who's committed to long-overdue Fed reforms. This is essential for future Fed effectiveness, credibility and political independence,†El-Erian says.
Chief among the tools Warsh has already ditched is forward guidance – the explicit signalling of the likely future path of interest rates. He also declined to join other Fed policymakers in creating dot plots on a graph showing how the economy and inflation are expected to develop over the next couple of years.
Among Warsh's 15 appointments to five subject committees is Lord Mervyn King, the former governor of the Bank of England, considered a founding father of inflation forecasting, but who has since argued that trying to predict the future is a fool's game.
In King's 2022 book Radical Uncertainty, he argues that central banks should drop the idea that consumers and businesses act like atoms in a physics experiment because it strips out emotional responses to economic events.
King says central banks should take more account of uncertainty in how people react and ditch a heavy reliance on economic models that claim to predict what is likely to happen.
He describes forward guidance as “silly†when no central bank knows what the interest rate will be in six months or two years' time. “It will depend on what is happening in the economy,†he says.
El-Erian calls forward guidance “spurious accuracyâ€. What financial markets and the public need to know is the “reaction functionâ€. In other words, how the central bank will respond to different types of events.
Charlie Bean, a professor at the London School of Economics and a former deputy governor of the BoE, says that, so far, Fed watchers don't have guidance on either the path of rates or the central bank's likely reaction to developments in the economy.
“Warsh is getting in a bit of a mess in the way he is not giving a guide to where rates are going and also not talking about how changes in the economy will affect rates,†said Bean. “It means he is not saying anything of substance.â€
The Fed held rates in July and financial market betting expects a hold again in September, though a rise is thought possible. Markets anticipate at least one, and possibly two, quarter-point increases by the middle of next year, taking the Fed's target rate from its current 3.5-3.75% range to 4-4.25%. Will market betting prove reliable? Nobody knows.
The Bank of England suffers a post-Covid hangover
While the BoE is widely considered to have acted consistently since the start of the Iran war – saying it will raise the cost of borrowing should there be any signs of persistent inflation. However, the decision to hold the Bank Rate steady at 3.75% so far this year could come under pressure.
The UK consumer price index (CPI) dropped to 2.6% in June, but some analysts expect it to rise to 2.9% or even 3% when July's figures are published by the Office for National Statistics on 19 August.
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A majority of the nine-member monetary policy committee (MPC) are wary of increasing interest rates when it will have little effect on global oil prices, aware that higher borrowing costs could depress an already weak UK economy.
Bean says the MPC is also under pressure from even more fundamental trends, including high and rising government debt.
The difficulty arises when governments are highly indebted and a central bank wants to raise interest rates to control inflation. A rise in the cost of borrowing increases the government's debt financing bill. Central banks must decide whether to cripple the government's finances or let inflation remain high for a longer period above its target.
This is a problem for the Fed's Warsh, too – after the US paid the highest borrowing costs to sell 30-year bonds since 2001, in an debt auction this month.
Neil Shearing, chief economist at the consultancy Capital Economics, says he has argued for many years that central banks will preside over high inflation for as long as western governments cannot control their debt-fuelled spending.
“The conceit is that central banks need to maintain 2% as their target while at the same time tolerating a slightly higher level of inflation. They cannot say it publicly, or even privately, because they would be accused of trying to dupe the public and more importantly, the financial markets,†he says.
Making matters worse, most inflationary shocks come from global events and restrictions in the supply of essential goods. Interest rate rises dampen consumer spending with little effect on the price of imported goods.
Nevertheless, financial markets predict the BoE will raise rates this year, possibly from as early as its next meeting in September on the path to pushing rates as high as 4.25% by late 2027.
The ECB goes rogue
Unlike the Fed and BoE, the ECB has raised the cost of borrowing this year. Critics say it moved too quickly. While the eurozone's central bank has freed itself from forward guidance, critics say the ECB remains confused about how to react when inflation begins to climb.
It raised interest rates in June after only a modest rise in inflation caused by the Middle East war and rising oil prices.
Many economists said the move was too early when much of the eurozone economy continues to be devastated by the energy shock that followed Russia's invasion of Ukraine.
Shearing said: “The ECB was clearly fighting the previous war and prematurely raising rates. The underlying picture in the eurozone is one of weakness.â€
Shearing is among many analysts who believe financial markets are wrong to expect the ECB will raise its main deposit rate by a quarter-point to 2.5% at its next meeting in September and possibly act again with a further quarter-point increase next year.
He says that while high oil prices put pressure on inflation, they act as a brake on economic activity, as a rise in interest rates would also do. A rate rise would be like kicking the economy when it is already down, and the ECB wouldn't win any plaudits for doing that.
