Inflation peaking, Central Banks hiking. Is the rationale rational?

The year 2022 was seen as a historic year of super-monetary tightening by central banks across the world to tame high inflation. This high inflation is commonly accepted as the result of global supply chain bottlenecks inclusive of the Russian invasion in Ukraine since February 2022. The dramatic increase in energy prices consequent to Russian-Ukraine war led inflation to be persistent and wide-spread across the world because of the energy-driven-world economy. Therefore, the present level of inflation is considered as 40-year high in the developed world.

However, despite primary causes of such a high inflation, the policy response by central banks across the world has been to raise interest rates faster to bring down inflation to their targets in the unknown future.

Therefore, this article is to highlight the present status of the world tight monetary policies as shown by last week’s monetary policy decisions of the US Fed (Fed), Bank of England (BOE) and European Central Bank (ECB) to hike interest rates by further 50 bps despite inflation has passed the peak and started falling. 

They are the world’s leading central banks who have world-wide impact on monetary policies because their currencies are the reserves of the world monetary system similar to the gold prior to the Breton Woods Agreement and establishment of the IMF.

Habit of central banks during inflationary times

Historically, inflation is bread and butter of central banks on the old hypothesis of inflation believed to be a result of monetary expansion that causes people to demand goods and services more than the existing supply. Therefore, the monetary policy rule followed by central banks during unhealthy inflationary periods has been to tighten monetary conditions by raising interest rates to reduce the bank credit expansion. Their present monetary model is to raise or change the overnight interest rate (known as policy rates) that central banks apply on transactions with banks.

Therefore, the inter-bank bank overnight interest rate is the conduit that passes the monetary policy effects across the economy. Although both the inflation hypothesis and monetary policy rule have not been empirically proved so far despite the present information era, central banks follow them as the God-given, despite broad mandates given to them under relevant public laws.

Therefore, irrespective of ground reasons for high inflation, central banks and old monetarists behind them interpret inflation as the situation of the imbalance of the economy arising from the demand for goods and services being greater than their supply. This causes central banks to use their monetary policy tools to reduce the growth of bank credit or money by hoping that such credit tightening would help slow the demand to match the supply in the economy over the time not specified. Therefore, central banks believe that the lower demand will drive down prices and inflation. This is the old inflation control hypothesis that central banks are accustomed to in their comfort zones although modern monetary concepts and market behaviours are different.

Last week’s decisions of the Fed, BOE and ECB

All three central banks commenced raising interest rates after inflation rose to significantly high levels above their targets of 2%. Their rate hikes of 50 bps in the last week are as follows. In response, many central banks raised their interest rates be consistent with.

• Fed - 50 bps to 4.25%-4.50% on 14 December 2022. This is the seventh consecutive hike since March 2022.

• BOE - 50 bps to 3.5% on 15 December 2022. This is the ninth consecutive hike since December 2021.

• ECB - 50 bps to 2.5% (marginal lending rate) on 15 December 2022. This is the fourth consecutive hike since July 2021.

The rate hike history of the current cycle of the three centra banks is given below.

Interest Rate Hikes by Fed, BOE and ECB, bps
Fed	BOE	ECB
March 22 - 50	Dec 21 - 15	July 22 - 50
May 22 - 75	Feb 22 - 25	Sep 22 - 75
June 22 - 75	March 22 - 25	Nov 22 - 75
July 22 - 75	May 22 - 25	Dec 22 - 50
Sep 22 - 75	June 22 - 25	Now 2.50%
Nov 22 - 75	Aug 22 - 50
Dec 22 - 50	Sep 22 - 50
Now 4.25%-4.50%	Nov 22 - 75
	Dec 22 - 50
	Now 3.50%

In addition, they have commenced a gradual balance sheet reduction as another tool to tighten financial conditions to be restrictive adequately with the inflation control phase.

Economic Conditions behind policy decisions

All three central banks focus on bringing down inflation back to 2% target and, therefore, side effects of policy tightening on the economy by way of reduced growth and increased unemployment are not considered. Some market analysists predict a recession in 2023/24 consequent to the high speed of the rate hikes in the current cycle.

The headline inflation numbers used by all three central banks have passed their peaks in recent months as follows.

Recent inflation Rate (%) – US, UK and EU
2022 Month	US	UK	EU
June	9.8*	9.4	8.6
July	8.5	10.1	8.9
August	8.3	9.9	9.1
September	8.2	10.1	9.9
October	7.7	11.1*	10.6*
November	7.1	10.7	10.1
*Peak so far

However, they raised interest rates by another 50 bps last week and announced that the rate hikes and policy tightening would continue in 2023 and beyond until they are confident that financial conditions are restrictive enough to bring down inflation back to 2% target in a sustained way.

They welcomed inflation reduction in monthly phase as at present and showed confidence in falling inflation. However, they declined to predict any rate cuts and policy loosening in the near future, given the present level of high inflation broad-based in the economy as compared to the long-term inflation target of 2%. Therefore, peaking inflation was not a factor considered by all three central banks. Therefore, all three announced to stay the course of further policy tightening.

Policy tightening to stay the course despite inflation falling from the peak

All three central banks are not complacent on the reduction in inflation from the peak based on the total consumer price index but assess the persistent price/inflation pressures by analyzing the major categories of the price index. Accordingly, the present ease of inflation has come from falling of food inflation attributable to improvements in supply chains towards pre-pandemic levels. However, energy, housing and services inflation are reported to be strong and rising further.

Energy inflation is a result of ongoing Russian-Ukraine war and not predictable. Housing (rent) inflation is to rise further due to fixed rate lease agreements to be renewed in 2023 with higher interest rates. Therefore, housing inflation cannot be expected to fall until rate cuts are implemented.

Service inflation relates to the tight labour market conditions and rising wages. As there is a structural shortage of labor force after the pandemic impact, services inflation cannot be expected to ease until unemployment rises to high levels together with recessionary economic outcomes in next two years resulting wages to come down. A considerable reduction in the GDP growth and employment are predicted by all three central banks as well as markets.

Therefore, inflation passing the so-called peak or falling in last few months is not a factor to stop or ease the present tightening phase of the monetary policy. In fact, the Fed Chairman responding to a question on possible rate cuts in the near future stated that “our focus right now is really on moving our policy stance to one that is restrictive enough to ensure a return of inflation to our 2 percent goal over time. It's not on rate cuts. And we think that we'll have to maintain a restrictive stance of policy for some time. Historical experience cautions strongly against prematurely loosening policy.”

However, as inflation is seen to be easing on food after a high speed of rate hikes so far, their question now seems to be not about the speed of hikes but about how high to raise rates by looking at the progress on inflation and assessment of financial conditions whether policy is restrictive enough to bring down inflation back to 2% target in a sustained path.

Therefore, markets make forecasts of what should be the terminal policy interest rates and how long they will stay before the rate cutting cycle starts. According to the Fed FOMC members’ forecasts, the fed funds rate is 5.1% in 2023 and 4.1% in 2024. Currently, markets predict a terminal rate of 3.0%-3.75% for ECB and 4.25% for BOE. These predictions change in response to updated outlooks for inflation, growth and unemployment.

However, inflation is predicted to fall towards the 2% target only in 2025 or later. Lower inflation predictions are primarily driven by the base effect of high price index reported during the past two years.

Lower inflation is predicted at a significant macroeconomic cost in terms of the reduction in GDP growth and increase in unemployment rate. These central banks are free to raise interest rates as unemployment benefits to people loosing jobs are available through the fiscal front.

Sri Lankan near-term monetary policy outlook

Sri Lankan central bank Governor recently stated at ADA Derana HYDE PARK interview that inflation which could have been peaked at 100% was peaked at 70% and now it is in downward path due to the tight monetary policy and, therefore, interest rates also should be coming down with that as a relief to all. However, this view is questionable on following grounds.

• Sri Lankan monetary policy is also designed on the inter-bank market-based policy models of the Fed, BOE and ECB. Only difference is that Sri Lankan central bank prints majority of money through primary purchases of government securities to fund the budget whereas others do it through the secondary market for the purpose of stabilizing market interest rates at their discretion within the monetary policy. All three central banks as highlighted above are to continue to raising rates despite inflation peaking and falling.

• Sri Lankan inflation peak and marginal fall in last two months have mainly come from the food category consequent to improvement in supply conditions as a result of improvement in fuel and electricity distribution supported with fiscal actions. However, given the current levels of exchange rate, import controls and taxes, non-food prices cannot be expected to fall any time in the future. Further, prevailing high cost of living, increased energy prices and rising wages in the informal sector would keep services inflation persistent.

• At present, policy interest rates in Sri Lanka are 14.5%-15.5% with 4%-6% inflation target in the monetary policy while the CCPI inflation is 61% in November 2022 and both annual average inflation and average core inflation continue to rise. The current phase of inflation is after a jump from 9.9% in November 2021 to the peak of 69.8% consecutively in September 2022. Therefore, the peaking and marginal fall of inflation in the last two months are not factors to be considered in monetary policy if it is geared purely for bringing down inflation back to 4%-6% in a sustained path. 

Therefore, when monetary policy statements of the Fed, BOE and ECB on last 14^th and 15^th are considered, Sri Lankan central bank Governor’s statement of interest rates to come down with presently downward inflation from peak at 70% does not comply with the y rationale and principle underlying the present monetary policy model for the control of inflation.

In fact, the present monetary policy model requires further rate hikes of high magnitudes in 2023 and 2024 until supply conditions are improved upon the stabilization of the foreign currency front, removal of import controls and a major rate of currency appreciation.

However, if the Governor is to respond that Sri Lankan economy is different from developed countries and now we need to lower interest rates to support the recovery of the economy from the current level of contraction (11.8% in the third quarter 2022) and to reduce the cost of budgetary financing (32% at present despite excessive monetary financing), the central bank must launch a new monetary policy model without delay to suit that view to be agreed with the IMF. The reason is that the present Sri Lankan monetary policy model adopted in developed market economy style is not suitable for it and IMF bailout conditions do not suport that sort of economic recovery.

Further, two views expressed by the Governor at the above media interview relating to Sri Lankan monetary policy as stated below are factually incorrect as there are no such provisions in the Monetary Law Act (MLA) that governs the monetary policy.

• The main objective of the central bank is the price stability or low and stable inflation at 4%-6%.

• There is a provision in the MLA that if the government cannot finance the budget deficit by raising money through domestic market and external market, the central bank can monetize the balance or print money and finance the deficit. When the central bank does that when the government fiscal policy or Treasury asking to print money, it is inflationary and the central bank cannot maintain the objective of inflation target.

(This article is released in the interest of participating in the professional dialogue to find out solutions to present economic crisis confronted by the general public consequent to the global Corona pandemic, subsequent economic disruptions and shocks both local and global and policy failures.)

P Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka

(Former Director of Bank Supervision, Assistant Governor, Secretary to the Monetary Board and Compliance Officer of the Central Bank, Former Chairman of the Sri Lanka Accounting and Auditing Standards Board and Credit Information Bureau, Former Chairman and Vice Chairman of the Institute of Bankers of Sri Lanka, Former Member of the Securities and Exchange Commission and Insurance Regulatory Commission and the Author of 10 Economics and Banking Books and a large number of articles publish. 

The author holds BA Hons in Economics from University of Colombo, MA in Economics from University of Kansas, USA, and international training exposures in economic management and financial system regulation)