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Regime shift: central banks will prioritise inflation over growth

29 March 2023 Azad Zangana, Senior European Economist and Strategist at Schroders
Azad Zangana, Senior European Economist and Strategist at Schroders

Azad Zangana, Senior European Economist and Strategist at Schroders

Inflationary pressures mean monetary policy must be tighter and more restrictive than it has been in the recent past. Higher for longer interest rates will be an important feature of a new regime in policy and market behaviour.

2022 was a landmark year for monetary policy. For some time, central banks had blamed rising headline inflation on a series of shocks: post-Covid supply chain issues, along with higher food and energy prices related to the war in Ukraine. These factors were seen as transient, and so policymakers felt that tightening monetary policy would not have much impact. However, it became apparent that these temporary cost increases had triggered pressures elsewhere, and that they had spread to other parts of the economy. Suddenly, inflation in services sectors was rising sharply, with wage growth being a major contributor.

Central banks acknowledged that the external shocks could no longer be looked at in isolation. These shocks, they came to understand, should be viewed in the context of wider changes in the global economy which had occurred over a much longer period of time. Past circumstances which had helped contain wages, the cost of imported goods, and energy prices, say, could no longer be relied on in the future. Gradually, policymakers accepted we’re in a new regime of supply side shortages and more frequent price increases.

Certainly, the pandemic had a profound impact on labour markets, especially where governments had not stepped in to protect jobs. For example in the US, the unemployment rate rose from 3.5% in February 2020 to 14.7% in just two months. As the economy re-opened, generous government aid and the movement in jobs made it very difficult for companies to hire people back and to respond to pent up demand. This helped return the unemployment rate to pre-pandemic levels by mid 2022, and drove wage growth up.

Total private sector average hourly earnings reached 5.3% in 2022, which remains the highest reading since the series began in 2008. The same series for the production only sectors has a longer history, and on this measure, earnings growth in 2021 reached 6.4% - the most elevated since 1981.

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