Central banks can only tackle inflation by harming the economy, says Paul Diggle, chief economist, abrdn
The “inconvenient truth”, he says, is that to bring down high inflation will require a weakening of the economy, a bitter pill to be swallowed as people struggle to see their bills.
“Economists call it ‘demand destruction’, but to put it more bluntly, it means quashing the booming labour market and raising unemployment.”
The more positive news is that both the US and Europe have endured some rate rises and are now seeing headline inflation fall.
“Core inflation, which excludes volatile food and energy prices, is also coming down in the US and Europe. But this still isn’t happening quickly enough, which is why both the US Federal Reserve and the European Central Bank are signalling more rate rises ahead.”
In the UK, unfortunately, it’s different, he continues.
“In the UK, the bad news is that the problem is much more entrenched: core inflation isn’t just sticky, it’s actually rising. The Bank of England’s chunky 0.5% rate hike this week will likely be followed by multiple additional hikes in the months ahead.”
Higher interest rates will inevitably lead to higher mortgage payments, more cautious business investment decisions, and probably a recession in many developed market economies.
“As these impacts become apparent, central banks will find themselves under scrutiny not just for high inflation, but also for the economic weakness that is the necessary remedy. And governments will find it very tempting to push in the opposite direction.”
In the UK, a wave of cheap fixed-rate mortgages, many taken out during the pandemic-era stamp duty holiday, will soon reset at much higher rates (see chart below).
Diggle points out: “For a Conservative government behind in the polls 18 months before an election, the desire to offer some form of mortgage relief scheme will be high. The rub is that this would be counter-productive to the economic pain that central banks must now inflict.”
Diggle accepts that it may now be too late to avoid recession as a necessary cost of bringing inflation down.
“Unfortunately, the situation now is the result of an earlier policy error by major central banks, and indeed swathes of the economics profession more broadly, of failing to spot ingrained inflation pressures. It will have painful real-world consequences for families and businesses.”
Regardless of the pain, Diggle says it would be a big mistake not to swallow the bitter medicine: “The policy error now would be to end the fight against inflation prematurely or give in to the temptation to use fiscal policy to counteract monetary tightening. That could lead to a more painful adjustment further down the road.”
Chart: Almost all UK mortgage holders due to refinance in the next year are on rates of less than 2.5% (number of mortgages due to refinance, by current interest rate)
Source: ONS, abrdn, June 2023
[Main image: frans-ruiter-x1Py2nXR-wc-unsplash]
