Policymakers face a difficult decision

FED decided to hike rates to control inflation.

As central banks lift policy rates, they hope and expect that demand in their economies will be cut back, and the better balance between supply and demand will help curtail inflationary pressure. However, there seem to be a number of reasons why this might not happen to their liking.

One way to look at this is through the channels that tighter monetary policy is supposed to operate. For instance, as policy rates and mortgage rates rise, so does demand in the housing market as fewer people can take on the higher mortgage costs. Another route is through the labour market, as firms see an impending slowdown and cut back on their demand for labour, pushing the unemployment rate up. But in each case, it seems that supply dynamics are so weak that hiking rates may prove the equivalent of pushing on a piece of string.

If we go back to housing, we see that in many countries, such as the US and the UK, the supply of housing is very weak. This might be due to low rates of new housing construction. In the US, for instance, annual housing starts are still more than 20% below the peak levels from sixteen years ago. Even in the UK, which did not experience the same sort of housing boom as the US, housing starts are still below 2006 levels. The result is that the inventory of housing for sale is very low. In the US, for instance, the inventory of existing homes is under one million, or less than a quarter of the levels seen at the peak in 2006. If the problem is supply rather than demand, it is hard to see that higher interest rates are likely to cool the housing market as much as policymakers might hope.

There are similar supply issues in the labour market as many countries, not least the US and UK, are seeing very high, if not record, vacancy rates. This, in part, is a legacy of the pandemic as former workers make the lifestyle choice not to offer themselves for employment. The point here is that, even if higher policy rates cut demand in the economy for goods and services, it still seems likely that firms will have high demand for labour as they try to fill many of these vacancies. Of course, vacancies are likely to fall, but if there’s still this core pile of vacancies that firms want to fill, it seems likely that the unemployment rate will be less responsive to rate hikes than we have seen in the past and perhaps insufficiently responsive to help the fight against inflation.

Once we look globally, we can also see difficulties with supply that policymakers at the likes of the Fed and Bank of England won’t be able to effect through higher rates. China’s COVID difficulty, for instance, could keep supply chains under some pressure and so keep prices elevated, and then there’s the persistent upward pressure on energy prices as much of the world tries to find alternative suppliers to Russia.

The bottom line is that policymakers will find it hard to control inflationary pressure as many of the factors pushing prices up are more about supply than demand, and that’s something over which central banks have little control. Demand is more amenable to monetary policy, but central banks will be willing to cut back demand sufficiently to match the reduced supply in housing, labour markets, and global supply chains. Even recessions might not be sufficient to quickly rid policymakers and economies of the scourge of higher prices.

It will likely lead to a choice whereby policymakers will have to decide whether to accept higher levels of inflation than their targets, or whether to drive economies into significant downturns. "We suspect that they will choose the former and that might not necessarily be a bad thing, as it was not that long ago that most central bankers were complaining that inflation was too low," Mr. Steve Barrow, Head of Standard Bank G10 Strategy, said.