Inflation gives central banks a challenge to ease rate hikes

They also need to balance between disinflation and the global financial market.

The head of the Monetary Authority of Singapore (MAS) revealed that despite the news that the global headline inflation peaked at 5.6% in the fourth quarter of 2022 (Q42022), central banks are facing the challenge of securing a return without harming economic growth or financial stability.

In his speech during the IMAS-Bloomberg Investment Coverage, MAS Managing Director Ravi Menon said that financial institutions such as the US Federal Reserves, the European Central Bank, and the Bank of England shifted their tightening to a more moderate pace. 

However, with inflation still well above targets, some market participants expected the cycle “will end soon,” and central banks are “excessively optimistic” while easing their rate hikes.

Menon also said that the banks are also challenged in balancing between disinflation — slowing down price inflation temporarily — and the functioning of the global financial market, “especially if inflation gets stuck too high a level.”

The speed of disinflation, according to Menon, will depend on these three uncertainties — the continued labour market tightness even in advanced economies, an infrastructure-led rebound in China, and a surge in food and energy prices.

This kind of synchronised policy tightening, combined with the fact that monetary policy operates with long lags, caused complex spillover effects that could either help dampen or exacerbate inflation and price hikes domestically.

“If a policy has tightened at a pace that does not consider the effects of previous hikes, we risk a deeper economic downturn or financial stresses.  But if policy tightening ends prematurely, we risk destabilising price expectations, entrenching inflationary pressures, and eroding central bank credibility,” Menon said.

Because of this, financial markets might adjust to the policy tightening of central banks and a possible increase in interest rates. However, according to Menon, they will have a hard time doing so.

“When interest rates rise rapidly, future cashflows will be discounted faster than the current cashflows can grow. As a result, most financial assets, which represent a stream of future cashflows, will do badly,” Menon said.