That’s ultimately what worries central banks. It’s not that current energy prices justify higher interest rates. Officials, at least in Europe, can live with inflation of 3–3.5% if it’s short-lived – and here in the UK, that’s where we’re headed even with the latest price rises.
It’s that policymakers have to set interest rates based on risks. If the probability of dramatically higher energy prices has risen, then so too has the risk of it spilling into wages and persistently elevated inflation. It’s why the ECB is likely to hike rates in September. It’s why the hawks at the Bank of England will keep pushing for higher rates next week, even if a hike is very unlikely this month. And it’s why Fed Chair Kevin Warsh worries about five years of above-target inflation becoming six or seven.
Investors think this way too. Many might agree with us that the ECB need only hike once more as things stand; 55% of our live webinar audience said so this week. But market expectations are really a weighted average of different scenarios for interest rates, not a point estimate. Speak to any rates trader, and they will tell you how painful it has been trying to bet against rate hike expectations over recent months.
Yet that comment from Lagarde this week on second-round effects shouldn’t be taken lightly. It is a subtle but important hint that the case for rate hikes beyond September is not yet clear-cut. And unless this crisis really does get much worse, our view is that central banks are likely to underdeliver on what markets are now pricing.
Speaking of which, do join me for the second episode of our summer webinar series on 6 August, where I’ll be quizzing our US expert James Knightley on how the Fed could avoid rate hikes entirely. And if you can’t wait until then, check out his video this week explaining why the inflation outlook might be about to get a lot better.
James Smith
