The world’s top central bankers have warned that the era of low interest rates and moderate inflation has come to an end following the “massive geopolitical shock” from Russia’s invasion of Ukraine and from the coronavirus pandemic.
Speaking at the European Central Bank’s annual conference, Christine Lagarde, its president, Jay Powell, chair of the Federal Reserve, and Andrew Bailey, Bank of England governor, called for rapid action to curb inflation.
They said failing to raise interest rates quickly enough could allow high inflation to become embedded and ultimately require more drastic action by central banks to bring price growth back to more moderate levels.
“The process is highly likely to involve some pain, but the worst pain would be from failing to address this high inflation and allowing it to become persistent,” said Powell.
Speaking in Sintra, Portugal, the central bank bosses said the pandemic and the Ukraine war were reversing many of the factors that had spurred more than a decade of ultra-low inflation among most developed economies. They warned that the splintering of the global economy into competing blocs risked fracturing supply chains, reducing productivity, raising costs and reducing growth.
“I don’t think that we’re going to go back to that environment of low inflation,” said Lagarde. “There are forces that have been unleashed as a result of the pandemic [and] as a result of this massive geopolitical shock that are going to change the picture and the landscape within which we operate.”
“Some would argue that the place where you manufacture [or] the place from which you provide services is going to be decided by different factors than just cost,” the ECB president added. Whether certain locations were politically “friends or foes” was likely to be relevant, she added.
Powell said these shifting dynamics would force a rethink over how the world’s central banks operate given that the low-inflation environment “seems to be gone now”.
“We’re living with different forces now and have to think about monetary policy in a very different way,” he said. Forecasting inflation in this environment had become a much more challenging task, he added. “We understand better now how little we understand about inflation.”
Bailey said there had been “a sea change” in the way economies work, and in the UK Covid was “leaving a structural legacy on labour markets and the way they behave”, with lower employment and higher risks of excessive pay increases.
Lagarde said the Ukraine war was hitting Europe harder than most other regions in the form of higher energy and food prices, meaning the continent was “not in the same situation” as the US and other countries.
But she warned that “what happens on the energy front [and] what happens on the war front” will affect inflation expectations. This could require the ECB to shift from its current “gradual” approach to raising interest rates — starting with a quarter percentage point rise in July — to a “more determined” policy stance.
Powell vowed to prevent a “higher inflation regime” from taking hold in the US, underscoring the central bank’s willingness to rapidly raise rates this year. The Fed has resorted to measures last used more than 30 years ago, raising interest rates by 0.75 percentage points earlier this month to bring the federal funds rate to a new target range of 1.5 to 1.75 per cent.
Top officials have signalled another big rate rise at the next policy meeting in July, with the benchmark policy rate reaching roughly 3.5 per cent by year-end.
Lagarde said Europe’s economy was also being buffeted by a shift from higher spending on goods during the pandemic to more spending on services such as tourism and travel, which was propping up eurozone growth but also creating “a series of shocks” that fuel extra price pressures.
The ECB president said central banks and governments were no longer working “hand-in-hand” as they had done during the pandemic and instead it was now important for fiscal policy to become more “targeted” and “sustainable”.