Inflation worries handcuff Central Bankers

With flagging economies and worries about austerity measures further crimping growth, about the last thing central bankers from the U.K. and Europe need to consider is combating inflation. But that is exactly what is being heaped upon decision-makers at the moment.

In the U.K., the Bank of England might be forced to raise interest rates in an effort to thwart the inflation pressures being exerted on the economy. It was recently reported that consumer inflation in the U.K. for December rose at an annualized pace of 3.7 percent, up from 3.3 percent in November, and well above the Bank of England's targeted 2 percent rate. In the meantime, inflation in the Euro area rose to a 2.2 percent annualized pace in December, up from 1.9 percent in November. That leaves European Central Bank Chairman Jean-Claude Trichet in a similarly uncomfortable quandary since that figure exceeds the sub-2 percent target for the Euro area as well. And yet, recent musings from these central banks have had a hawkish overtone. Unlike the Federal Reserve in the United States, which has the dual objective of maintaining stable prices and maximum employment, the central banks of England and Europe are more singularly focused on price stability as the objective. As a consequence, while not indifferent to the social issues of employment, great attention is given to the price of goods and services.

The delicate balance these central banks must strike is fending off rising prices while at the same time remaining accommodative to the needs of the still fragile economic recovery both are grappling with. While similar issues, each has distinctly different complexities to deal with in solving for a solution. The Bank of England serves the needs of a single country, albeit one that is implementing measures to restore its fiscal posture to a position of health. A regime of austerity and a Value Added Tax (VAT) rise are the means by which policymakers are attempting to bring fiscal order to the U.K. but the concern at the moment is that these efforts may further slow economic activity at a time when the margin for a decline in the still relatively anemic pace of growth has little room for a policy error. Unlike the U.K., European central bankers have a two speed economy to grapple with and, therefore, must account for the varied needs of multiple countries. On one hand for instance, Germany just logged a year in which its economy expanded at the fastest pace in twenty years. On the other, the peripheral countries of Greece, Ireland, and Portugal are struggling to grow fast enough to overcome their respective debt burdens, and rising inflation only serves to endanger their already precarious ability to survive a default.

Central bankers are attempting to divine the appropriate balance that enables growth to manifest in the context of a pricing schematic that is teetering on intolerance. We expect that the Bank of England may begin tightening before the European Central Bank and both perhaps even more quickly than their U.S. counterpart. However, monetary policy will likely remain very accommodative in the near term as any move toward tightening, given the already stiffening headwind of fiscal austerity, would cause growth across the continents to soften. Central banking officials are somewhat divided about the appropriate policy action due to some uncertainty regarding the components of inflation that could prove temporary and allow inflation readings to fall back to more tolerable levels. Were this to hold any intervention would be deferred. The risk facing policymakers waiting for clearer indications of whether the current level of inflation is transitory or not, is that it could worsen making policy decisions even more acute. At the moment at least, we believe rising market expectations for a pending rate hike are overzealous.