New York CNN –
Central bankers around the world are sending a message: slow and steady will not win the race against inflation.
“If we don’t raise interest rates now, high inflation may be with us for some time to come,” Bank of England Governor Andrew Bailey said after unexpectedly raising interest rates by half a percentage point on Thursday.
Although inflation is slowing in many countries after more than a year of rate hikes, it remains above the 2% target of many central banks.
Raising interest rates is the main tool available to central bankers to bring down inflation. At the same time, research suggests that there is a lag effect of at least 12 months between the time a central bank acts and the time its actions are felt throughout the economy.
That’s why the Federal Reserve suspended rate hikes at its June meeting after raising rates 10 times in a row since March last year. Still, many Fed officials are signaling that interest rates could rise again next month as, like Bailey, they don’t want to risk losing control of inflation if they don’t act now.
Why does now seem such a critical time?
Central bankers face a very delicate balancing act. For a while it seemed as if they could raise interest rates without significantly damaging their economy. But now time is catching up. And with inflation still higher than they would like, the risk of doing too much to bring down inflation is just as great as the risk of not doing enough.
Christine Lagarde, President of the European Central Bank, recently compared raising interest rates to a plane flying to a destination.
“In the beginning, the plane has to climb steeply and accelerate quickly,” she said in a speech she gave earlier this month. “But as it nears its target altitude, it can reduce acceleration and maintain its existing airspeed. The plane has to climb high enough to reach its destination – but not so high that it exceeds it.”
“The plane is still climbing – and it will continue to fly until we have enough speed to sustainably glide and land at our destination,” Lagarde said two weeks before the ECB hiked interest rates by a quarter of a point. Consumer prices in the 20 countries that use the euro rose 6.1% in May, compared with 7% in the previous month.
Another way to interpret Lagarde’s analogy is that if the plane doesn’t climb high enough to a safe cruising altitude, the plane could experience excessive turbulence, preventing it from reaching its 2% inflation target.
This is what worries central bankers.
One of the reasons central banks are struggling to contain inflation is that certain parts of the economy do not respond to interest rate hikes. For example, in the US, non-energy service prices rose 6.6% year-on-year, according to CPI data for May. While prices have increased by 5.2% in the last year compared to 2021, IIncreased service prices have proven to be persistent.
It is more difficult for central banks to contain inflation when it becomes stubborn or persistently high. But it’s not impossible. All that matters is how much pain they are willing to inflict on an economy by raising interest rates to bring inflation to the desired level.
But taking too long to make that decision also has consequences, said Michael Bordo, economics professor and director of the Center for Monetary and Financial History at Rutgers University.
“The longer they wait, the more tightening it will take to bring inflation back down,” he told CNN. Research shows that if left unchecked, raising interest rates could make inflation even more stubborn and harder for central banks to control.