Interest rate dilemma for central banks as inflation rises but growth slows

The Federal Reserve, the ECB and the Bank of England appear unclear on how to tackle inflation amid the Iran war

New UK cost of living crisis looms as rising energy bills lift inflation

Inflation rates have been falling across the industrialised world, but fears that the Middle East war will raise oil prices means central banks are sitting on their hands when they should be raising interest rates to subdue inflationary pressures.

The US Federal Reserve, the Bank of England and the European Central Bank are still smarting from the criticism of their inaction in 2022 when inflation soared above 10% in the UK and eurozone, and over 9% in the US.

Central banks were plagued by accusations that they moved too slowly to confront inflation in the months after the Ukraine war started, when post-pandemic consumer spending was already stoking prices on everything from food to construction materials.

It’s now been five years since they all met their 2% inflation target and now they are asking themselves whether the continuing blockade of the strait of Hormuz will mean a sixth or seventh year of target-busting prices growth?

US inflation edged lower to 3.4% in July from 3.5% in June and 4.2% in May, largely in response to falling petrol prices.

Since the Bureau of Labor Statistics collected the data, the price of a barrel of Brent crude has risen again to about $90 – a figure that will push up the price of energy and transport across the US in the second half of the year.

Fed officials are asking whether US inflation will climb back towards 4%, double its target.

The US central bank’s new boss, Kevin Warsh, has instigated an all-embracing review of the Fed’s operations based on the advice of 15 outsiders that he says are among the most eminent experts and economists of the age.

Many analysts have applauded him for recognising that a series of inflation shocks dating back to the arrival of Covid-19 have undermined the integrity and durability of central bank forecasting.

Mohamed El-Erian, an economist and professor at the Wharton Business school, said Warsh recognised that many of the shibboleths of monetary policymaking had proved flawed.

“The key issue for me is having someone there who’s committed to long-overdue Fed reforms. This is essential for future Fed effectiveness, credibility and political independence,” El-Erian says.

Chief among the tools Warsh has already ditched is forward guidance – the explicit signalling of the likely future path of interest rates. He also declined to join other Fed policymakers in creating dot plots on a graph showing how the economy and inflation are expected to develop over the next couple of years.