'Task ahead for central bankers not easy with inflation jitters, fear of deflation'

Inflation has been the bugbear of world policy makers in the COVID-19 induced 'new normal' world. The commentary on inflation has gradually evolved over the period. Central bankers have long considered the post COVID-19 inflation to be 'transitory'. For instance, US Fed Chairman had continued to highlight supply constraints in the form of semi-conductor shortages for the auto industry as one of the reasons for high US inflation. In her recent commentary, President Lagarde of ECB continues to judge the current spike in inflation as mostly transitory and expects it to come down over the course of 2022.

However, inflation has refused to come off as expected and such sustenance has started to worry market participants. Input supply shortages and housing price increases have prolonged inflation in both advanced and developing economies. Shortages of natural gas and the shift to cleaner energy have led to large swings in oil prices globally. There are also fears that such a shift to clean energy could keep the metal prices elevated for longer. Therefore, the risk for inflation remaining higher than the baseline levels in most economies is not insignificant and more importantly, a temporary de-anchoring of inflation expectations can lead to higher, more persistent and volatile inflation.

The IMF staff's baseline forecasts suggest that, for the advanced economy country group, on average, headline inflation will peak in the final months of 2021 and will decline to about 2 percent by mid-2022. For EMEs and developing economies, the IMF estimates headline inflation to drop to around 4 percent after a peak of 6.8 percent later this year. While risks remain tilted slightly to the upside over the medium term, the IMF argues that inflation expectations are still anchored both in the advanced and emerging market economies.

Some central banks have already taken the plunge and their communication have taken a hawkish turn; some even have hiked rates or reduced their support to the bond market. For the developed market central banks, the Bank of England has started to sound hawkish resulting in the market advancing its expectation for the BoE. Markets now expect the BoE to raise rates within the next six months compared to an earlier expectation of end-2022. The center of attraction now is the US Fed, expected with certainty to reduce its QE programme. More importantly, the market focus will be on the pace of reduction and the communication from Fed on the assessment of inflation.

But overall, inflation hawks believe that the policy makers are behind the curve and that the central bankers should start worrying about its own credibility. The loss of credibility of a central banker would effectively mean a bigger chance of unhinging of inflation expectations and volatility in the financial markets, leading to loss of output. Such instances are seen in the past, but these were more concentrated for central banks. In the current instance, this has spread to most central banks of the world.

The task ahead for the central bankers is not easy. While there are inflation jitters on one hand, there is also a fear of deflation as more evidences are emerging that some of the larger economies are slowing. Q3 real GDP in the US showed a moderation of growth momentum to 2 percent QoQ SAAR, from 6.7 percent in Q3. Supply side bottlenecks and input shortages, along with high global oil prices could be expected to pull down global growth.

Thus, central bankers are on a wait-and-wait approach and only time can say if they are right in this approach. Policy missteps by the central banks of an earlier tightening and precipitating the slowdown is best avoided. Do also note that some central banks like the ECB also have a legacy of hawkish errors. In 2008, it hiked on the eve of the credit crisis while in 2011, it raised rates when the sovereign debt crisis was deepening.