Not since Ronald Reagan was president and Paul Volcker was the hardline chairman of the Federal Reserve has US inflation been as high as 7%, so inevitably the latest jump in the country’s cost of living index will have consequences.
The US central bank has historically tended to fear deep recession more than runaway inflation, scarred as it still is by the legacy of the Great Depression. The Fed, however, cannot ignore the risks of a wage-price spiral developing and will be forced to act.
In part, that’s because of what’s been happening to core inflation, a measure that strips out volatile elements of the consumer prices index such as fuel and food. This rose sharply in December to an annual rate of 5.5%, making it harder for the Fed to argue inflationary pressures will be fleeting. The price of used cars, clothes and air fares all registered hefty increases.
Increases in interest rates are inevitable as a result. Wall Street expects the Fed to start pushing borrowing costs up in March, with four quarter-point jumps this year and a further four in 2023, taking them to just over 2%. This is a long way short of the shock treatment administered by Volcker – official borrowing costs peaked at 20% in 1981 – but it will still be enough to slow the US economy and make life harder for the Democrats in November’s midterm elections.
The Fed’s chairman, Jerome Powell, knows there is a risk that an over-aggressive approach to inflation could send Wall Street into a tailspin. He is also aware that many emerging and developing economies, especially those that have borrowed heavily in dollars, are vulnerable to higher US rates. In the words of the Roman emperor Augustus, he would be advised to make haste slowly.
Other central banks face the same dilemma as the Fed, under pressure to tackle the rising cost of living but worried about moving too fast. UK inflation will hit 6% in the coming months and the financial markets expect the Bank of England – which has already raised interest rates once – to push up borrowing costs to somewhere close to 1% by the end of the year. Pressure will mount on the European Central Bank to act too. The days of ultra-cheap money are over, at least for now.