Why don't interest rate hikes stop inflation?

Labor market constraints and home ownership are delaying a return to price stability, according to a new Financial Times report.

Central banks are raising interest rates at the fastest rate since the 90s, but serious inflation problems have yet to be brought under control. The world's 20 largest economies have raised rates by an average of 3,5 percentage points since the tightening of borrowing costs began. However, the chairman Federal Reserve, Jay Powell, and the president European Central BankChristine Lagarde, do not expect inflation to hit the 2 percent target before 2025. Despite the fall in consumer price indexes, central bankers point to higher core inflation, labor market constraints and pressures in the service sector as reasons for the continued rise in prices, the FT reports.

Why does inflation persist despite aggressive interest rate hikes?

Monetary policy always operates with a delay of about 18 months for the impact of a one-off interest rate hike to fully manifest itself in spending patterns and prices. Central banks started raising interest rates less than a year and a half ago in the US and the UK, and less than a year ago in the eurozone. Only recently have they crossed the neutral level, which means actively restricting the economy. However, some central bankers and economists believe that the delays may be even longer and the effects of tightening monetary policy this time weaker. They argue that despite the sharp rise in the cost of borrowing, economic growth has proven surprisingly resilient, especially in the service sector, which accounts for the bulk of manufacturing in most countries.

A shift from manufacturing to services, which require less capital, may also result in slower penetration of the effects of a more restrictive monetary policy. Structural developments in housing and labor markets between the 90s and the current period may explain why rate hikes have had a faster and more intense impact in the past. Changes are observed on the real estate market, which delay the effects of interest rate increases.

In some countries, the number of households owning their own property or renting has increased. Fixed-rate mortgages are now more popular, meaning that higher central bank rates don't have an immediate impact on household purchasing power.

In addition, the effects of the pandemic have a far-reaching impact on the labor market. Widespread labor shortages persist, especially in the service sector, fueling wage growth and thus inflation. Service companies may currently retain staff, fearing recruitment difficulties in the event of economic growth. As a result, the sector may be shielded from the effects of tightening monetary policy for a longer period than before, according to the FT.

"Inflation is temporary"

Central bankers stubbornly insisted that inflation would be short-lived, delaying the abandonment of the aggressive and loose monetary policy that had been in place for decades. These delays made it harder to control inflation at higher interest rates as price pressures spread from a problem affecting a small number of products affected by supply chain disruptions to a broad phenomenon involving almost all goods and services.

The Bank for International Settlements warned last year that if interest rates are raised too little or their impact is significantly delayed, countries could find themselves in a situation where high inflation becomes the norm. There is a risk that a return to 2 percent inflation will require borrowing costs to be raised to such an extent that it would threaten the stability of the financial system, according to the FT report.

The problems of several medium-sized banks in the US and Credit Suisse's difficulties this year are partly attributed to higher borrowing costs. Should economic growth slow down, experts predict greater pressure on central bankers as they try to bring inflation under control. Jennifer McKeown, chief economist at Capital economics, now provides for higher interest rates “will lead most developed economies into recession in the coming months”.