There’s an economic scenario out there that scares central bankers more than any other — a sudden inflation jump that can’t be tamed by slow and steady interest rate rises.
A rise in interest rates can take the heat out of the economy, calming prices, because it makes mortgage repayments and other types of debt more expensive.
The problem is that it’s a bit of a blunt tool and can take a while to have an effect.
Kristen Forbes, a member of the Bank of England’s Monetary Policy Committee touched on it this week in an interview with The Telegraph. She called for rate hikes to start early to get a head start on a potential inflation boost that catches policymakers unawares.
Outgoing MPC member David Miles also echoed her sentiments on BBC’s Newsnight last night and said rates will rise “pretty soon.“
This is pretty much what happened in the US in the late-1960s, when the inflation rate suddenly tripled within two years, as Bank of America Merrill Lynch pointed out in a research note.
In 1966 core inflation started the year at just 1.3%, but by year-end the numbers had flipped to 3.1% and was still climbing. During this period the Fed belatedly hiked rates. However, this triggered a dramatic drop in housing activity and massive political pressure on the Fed. The Fed backed off, allowing in a further rise in inflation.
This is the BAML hell chart:
The BAML analysts don’t see a repeat of this scenario anytime soon, thanks mostly to the increased power corporations now exert over their employees:
Fortunately the structure of the US economy has changed dramatically since the 1960s. Unions are no longer powerful, contracts no longer have automatic cost-of-living adjustments, global competition has gotten a lot tougher, faith in the anti-inflation powers of the Fed is high, and the Phillips Curve has gotten a lot flatter. So even with a lot of bad luck and bad judgment, a replay of the 1960s is unlikely.