Why some central banks are rushing to raise interest rates now

New York

Central bankers around the world are delivering a message: Slow and steady will not win the fight against inflation.

“If we don’t raise interest rates now, high inflation could stay with us longer,” 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 interest rate hikes, it remains above the 2% level many central banks aim for.

Raising interest rates is the primary tool central bankers have at their disposal to bring down inflation. At the same time, research suggests that there is a lag effect of at least 12 months from when a central bank acts until its actions are felt throughout the economy.

That is why the Federal Reserve halted interest rate increases at its June meeting after 10 consecutive increases since last March. Still, many Fed officials are signaling that interest rates could rise again next month since, like Bailey, they don’t want to risk losing their grip on inflation if they don’t act now.

Why do now seems to be such a critical time?

Central bankers have a very delicate balancing act. For a while it seemed they could raise interest rates without significantly damaging their economies. But now time is catching up. And with inflation still higher than they want it to be, the risk of doing too much to bring down inflation is on par with not doing enough.

Christine Lagarde, president of the European Central Bank, recently compared interest rate increases to a plane flying to a destination.

“At the start, the plane has to climb steeply and accelerate quickly,” she said in a speech earlier this month. “But as it gets closer to the target altitude, it can reduce acceleration and maintain its existing airspeed. The aircraft has to climb high enough to reach the target – but not so high that it overshoots it.”

“The plane is still climbing – and it will continue until we have enough speed to glide sustainably and land at our destination,” Lagarde said two weeks before the ECB raised interest rates by a quarter of a percentage point. Consumer prices in the 20 countries that use the euro rose by 6.1% in May, from 7% a month earlier.

Another way to interpret Lagarde’s analogy is that if the plane does not climb high enough to a safe cruising altitude, it may encounter unnecessary turbulence that prevents it from reaching the 2% inflation target.

That is precisely what worries central bankers.

One of the reasons why central banks have struggled to bring down inflation is that certain parts of the economy do not respond to interest rate increases. For example, in the US, service prices excluding energy are up 6.6% compared to last year, according to data from the May Consumer Price Index. While prices last year were up 5.2% compared to 2021, It has become clear that high service prices are sticky.

It is more difficult for central banks to limit inflation when it becomes sticky, or persistently high. But it is not impossible. It’s just a matter of how much pain they are willing to inflict on an economy through interest rate hikes to get inflation to the desired level.

However, taking too long to make that decision has its own consequences, said Michael Bordo, an 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. That’s because research shows that inflation, if left untreated, can become even stickier and harder for central banks to control with interest rate hikes.

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