How do central bankers decide interest rates when inflation is so unpredictable?
The Federal Reserve, Bank of England and Bank of Japan all confront the same question this week: how do you set interest rates when inflation is being buffeted by forces well beyond your control? Writes Helen Thomas
Three of the world’s most important central banks meet this week, with the Federal Reserve, Bank of England and Bank of Japan all confronting the same question: how do you set interest rates when inflation is being buffeted by forces well beyond your control?
The Fed goes first, with markets now overwhelmingly expecting a 25bp hike after last week’s inflation data. Expectations have whipped around as investors adjust to life under Kevin Warsh, a chairman determined to provide less forward guidance and force markets to make up their own minds. But one inflation print should not make monetary policy, particularly when an unusually large contribution came from something as prosaic as mobile phones. Wireless telephone services prices jumped 5.9 per cent in August. There is an irony of history repeating itself here. Janet Yellen explicitly discussed the same category in October 2017, except then plunging wireless prices were helping to keep inflation down even as the Fed wanted to raise rates.
Yellen brushed the move aside. “It is common to see movements in inflation of a few tenths of a percentage point that are hard to explain,” she said, adding that such surprises “should not really be surprising”. Not everyone agreed. When the Fed eventually raised rates by 25bp that December, Neel Kashkari and Charles Evans dissented. Larry Summers had already criticised its willingness to engage in the “pre-emption of inflation based on the Phillips curve”: tightening because models said inflation ought eventually to rise rather than because it actually had.
Yellen carried on regardless and the market came with her. Before the September 2017 meeting, investors put the chance of a December hike at only around 50 per cent. By December it had risen to around 95 per cent.
Warsh may be preparing to perform the same trick in reverse. At Jackson Hole he stressed that policymakers should not rely on isolated data points and said he found it useful to “disaggregate the 199 individual components of the PCE price measure”. He noted that 54 per cent of its components had risen by more than three per cent over the preceding year, lower than the post-pandemic highs of 77 per cent but well above pre-pandemic averages. The latest reading has this proportion even lower at 46 per cent and on a declining trend. For all the headlines about stubborn inflation Warsh can therefore construct a perfectly defensible case for a hawkish hold: underlying price pressures are still too broad for comfort, but they are not obviously becoming broader. A central banker who has explicitly warned against reacting to individual data points can hardly allow one telephone bill to determine interest rates.
A political problem
Andrew Bailey would probably welcome such a narrow problem. The Bank of England governor is expected to keep Bank Rate unchanged on Thursday, but the meeting also brings its annual decision on quantitative tightening. Last September the Bank chose to reduce its gilt holdings by £70bn over twelve months. It is now expected to slow that pace to around £50bn.
That still means deciding whether to actively sell gilts rather than merely allowing them to mature, just as sovereign bond markets buckle beneath enormous issuance. Governments are not the only borrowers demanding cash: hyperscalers are increasingly tapping global credit markets to finance their voracious appetite for compute capacity. With every extra basis point on gilts adding pressure to Chancellor John Healey, supposedly technical decisions over the Bank’s balance sheet have become increasingly political.
Bailey discovered quite how political last week when Treasury Committee questioning descended all the way into questions over the 1844 Bank Charter Act and the accounting of seigniorage.
BOJ Governor Kazuo Ueda faces political interference of a more international kind. US Treasury Secretary Scott Bessent has waded into comments about Japanese fiscal policy and has been even more explicit on the monetary side. He recently told traders after intervention in the yen “I am the house now”, boasting that he has unusually good insight into what the Bank of Japan and Japanese policymakers will do.
The BOJ is expected to raise rates by 25bp to 1.25 per cent on Friday. But between Prime Minister Sanae Takaichi’s preference for reflation and American pressure for tighter policy and a stronger yen, Ueda increasingly looks squeezed between two governments.
Yet all this agonising over mobile-phone prices, gilt maturities and nineteenth-century monetary arrangements risks missing the larger point.
Brent is back above $100 as the conflict around Hormuz intensifies; Saudi Arabia’s East-West pipeline has been hit by drones and commercial shipping remains under attack. No central banker can conjure barrels of oil from thin air, repair a pipeline with a rate hike or retrospectively apply fertiliser to a failed harvest.
The world’s central bankers can debate the next 25 basis points as much as they like but it is the Middle East that will decide whether inflation gives them any choice.