CENTRAL BANKS ARE WINNING THE BATTLE AGAINST INFLATION. BUT THE WAR IS JUST GETTING STARTED / THE ECONOMIST

The end of the beginning

Central banks are winning the battle against inflation. But the war is just getting started

Politics and protectionism will make life difficult

The trajectory of inflation has not given central bankers much cause for celebration in recent years. 

But at the European Central Bank’s annual jamboree in Sintra, Portugal, this week, a touch of self-congratulation has been in the air. 

“I know it sounds a little bit arrogant,” confessed Christine Lagarde, the ecb’s president, on July 1st, but the unwinding of high inflation “is remarkable”. 

“We’ve made a lot of progress,” said Jerome Powell, the chairman of America’s Federal Reserve, the next day. 

Others agree. 

“Central banks have risen to the challenge” of high inflation, commends the Bank for International Settlements.

The data do indeed merit some satisfaction. 

After cumulative price increases between 2021 and 2023 of 15% in America and 18% in the euro zone, annual inflation rates now stand at just 2.6% and 2.5% respectively. 

Yet the time for mutual back-patting may be brief. 

Lower inflation, though welcome, does not mean a return to the relatively stable economy that prevailed before the pandemic. 

Several perils loom on the supply side, which could constrain growth and boost inflation, just as a return to populism in America and Europe threatens fiscal blowouts and more price pressure still. 

Central bankers may be winning the battle against inflation. 

The war is just beginning.

Consider the dangers to supply. 

Donald Trump has promised a 10% across-the-board tariff if he returns to the White House, and, after Joe Biden’s catastrophic performance in a presidential debate in Georgia on June 27th, investors and prediction markets think that a second Trump term looks more likely. 

The levy, and any retaliation by China, will push up the cost of imports. 

Climate change and surging investment in green infrastructure are helping keep commodity prices high even with global growth weak, according to the World Bank. 

And the risk of an escalation in the war in the Middle East hangs over the world economy.

What these potential shocks have in common is that, like the pandemic, they threaten to send growth and inflation in opposite directions. 

According to Goldman Sachs, Mr Trump’s 10% tariff would, if it provoked retaliation by America’s trading partners, add 1.1 percentage points to American inflation while marginally reducing growth. 

Euro-area output could fall by 1%. 

And that is without factoring in the additional damage caused by a 60% tariff on Chinese goods, which Mr Trump might also decide to impose.

In theory, central bankers should ignore supply shocks, which exert only a passing direct effect on inflation. 

In practice, with repeated bursts of inflation—let alone a surge as big as that which followed the pandemic—their inflation targets could come to seem merely theoretical. 

Yet their other option, of raising interest rates to squeeze inflation out of the economy quickly, would be painful. 

Were Mr Powell, Ms Lagarde or their successors to raise rates with every escalation in a trade war, say, the world economy would become far more volatile.

Layered on top of this is politicians’ renewed fondness for running up big debts. 

As the world has discovered, wars, pandemics and commodity crises are costly. 

Though tariffs raise government revenue, supply shocks tend to harm growth, making debts harder to repay.

Bond markets are already alert to lavish fiscal policy; investors took fright at the prospect of a victory for the populist right in France’s parliamentary poll, only to calm a little as a hung parliament appeared more likely after the first round of voting. 

Yields on ten-year Treasuries have risen as investors contemplate a Republican sweep in America’s elections in November, which would make deficit-financed tax cuts more likely. 

Such policies will only push up inflation, forcing central banks to raise interest rates—and putting them on a collision course with Mr Trump and other populist politicians.

A rocky road

The risk of a more inflationary world is still under-appreciated. 

At times the mood in Sintra did become sombre, but—notwithstanding their recent jitters—financial markets are for the most part priced giddily, as though the recent episode of inflation was an aberration, and stability will now prevail. 

More probably, the pandemic marked the start of a dangerous new time—one in which victories for central banks will be rarer and harder-fought.