Central banks revise inflation outlook, struggle to regain control

It has grown increasingly evident that central banks worldwide downplayed the threat of inflation as they persisted in implementing exceptionally low-interest rates and engaging in extensive asset purchases throughout 2021 and early 2022. 

However, a significant shift in monetary policy took place in mid-2022, resulting in substantial interest rate hikes. Within a year, the European Central Bank raised rates by 375 basis points, while the Federal Reserve implemented a 500-basis-point increase. Nevertheless, monetary policymakers around the globe are now facing greater challenges than anticipated. They have come to recognize that inflation is not merely a “transitory” issue, as previously suggested by Federal Reserve Chair Jerome Powell, but rather a persisting problem that may prove difficult to control. This is the current situation the world finds itself in. 

While there were discussions regarding the potential pause in tightening measures by certain central banks, the recent actions of the Canadian and Australian central banks caught the markets off guard. The Canadian central bank, due to ongoing inflationary pressures, decided to impose limitations on monetary tightening and announced a 25-basis-point increase in interest rates after a five-month hiatus. On the other hand, the Australian central bank raised interest rates by 25 basis points, reaching their highest level in 11 years, and cautioned that additional tightening might be necessary to achieve the desired inflation target. 

The Federal Reserve’s recent decision to adopt a “hawkish pause” and the possibility of raising rates later in the year has left investors disappointed. However, the central bank also announced that a reversal of rate hikes would not occur for at least two years, leading to further frustration. In contrast, the European Central Bank approved a 25-basis-point increase, pushing the deposit rate to its highest level since 2001. 

Read more: How interest rates, inflation, ESG, and urbanization impact UAE real estate sector

When the Federal Reserve initially began raising interest rates in March 2022, their primary objective was to curb inflation. This sparked discussions among economists, policymakers, and investors about the feasibility of achieving a soft landing for the economy. A soft landing refers to a scenario where the economy slows down enough to control prices without triggering a significant rise in unemployment. 

Despite a year-long decrease in inflation, the ongoing debate persists regarding whether the US economy can achieve a soft landing with confidence. 

The primary concern lies in the challenges faced by central banks, including the Federal Reserve, as they strive to determine the optimal duration for maintaining a tight monetary policy and identifying the appropriate timing for transitioning to an easing path. 

In May, core inflation in the United States, the preferred measure for central banks, registered at 5.3 percent annually. While this figure is lower than the 7 percent recorded in June 2022, it remains more than double the Federal Reserve’s inflation target of 2 percent. 

It is important to note that inflation rates are declining at varying rates across different regions, posing distinct challenges in each case. In the United States, inflation dipped below 5 percent after peaking at 9.1 percent. In the Eurozone, inflation has decelerated from its peak of 10.6 percent in the previous year to 6.1 percent in May. In the United Kingdom, inflation reached 8.7 percent in April, prompting the Bank of England to postpone potential interest rate hikes. In Latin America, inflation has started to recede, but central bank leaders remain cautious following the implementation of double-digit interest rate increases. 

The disruptions encountered in the banking sector, originating in the United States and spreading to Switzerland, have presented central banks with arduous decisions on whether to continue raising interest rates, temporarily halt them, or even reverse their course. 

Central banks are compelled to adopt an even more cautious approach, as they fear that a subsequent credit crisis could plunge the U.S. economy, and consequently the global economy, into a recession. 

Inflation in the GCC

In 2022, central banks responded to inflationary pressures by implementing tighter monetary policies and raising interest rates, following the lead of the Federal Reserve. However, the current situation presents a notable contrast as Gulf countries’ governments have demonstrated their adeptness in managing inflationary pressures and minimizing their impact on their respective economies. 

This positive development has garnered recognition from the International Monetary Fund (IMF), which recently projected a decline in the inflation rate for Gulf Cooperation Council (GCC) countries. The IMF anticipates a drop to 2.3 percent in the upcoming year, compared to the projected 2.9 percent for the current year. 

Regarding Saudi Arabia specifically, the IMF highlighted that despite robust economic activity, inflation remains low and is currently displaying signs of decline. This observation was made following the conclusion of the IMF’s Article IV mission to the Kingdom. 

As of April, the inflation rate in Saudi Arabia has maintained a steady level of 2.7 percent on an annual basis, comparable to the year-on-year change in March. The highest inflation rate recorded in the Kingdom within the past 12 months was observed in January, with a year-on-year increase of 3.4 percent. However, it has gradually decreased since February. 

The financial stability report of the Saudi Arabian Monetary Authority (SAMA) also indicates an expected decline in the inflation rate within the Kingdom. 

SAMA’s report highlights that inflation in Saudi Arabia has remained relatively low and is projected to remain stable. It emphasizes several factors that contribute to this stability, including the stability of essential goods, global food prices, and the strengthening of the US dollar, which helps alleviate upward pressures on imported goods within the country. 

In the United Arab Emirates, the central bank anticipates inflation to reach 3.2 percent in 2023. Meanwhile, inflation in Dubai reached its lowest levels since the beginning of the year, standing at 3.05 percent in May, compared to 3.27 percent in April. 

PwC (PricewaterhouseCoopers), in its bulletin, underscores the ongoing efforts of Gulf countries to diversify their economies and their economic resilience as they work towards achieving their national visions. These visions encompass various areas such as economic diversification, infrastructure improvement, digital transformation, fostering competitive work environments, and promoting workforce localization in the private sector. The economies of the Gulf Cooperation Council (GCC) countries have demonstrated notable flexibility and resilience in the face of global challenges. Through the growth of non-oil sectors and a heightened focus on sustainability, they have effectively pursued comprehensive transformation agendas. 

It is evident that central banks worldwide face formidable challenges, which have been further compounded by diminishing confidence in the performance of monetary policymakers. This situation has the potential to negatively impact the trajectories of economic recovery in these countries. 

For more news on the banking and finance sector, read here.