Consumer price inflation in , is the highest since the early 1990s and could rise further in the coming months (Chart 1). This should continue to generate uncomfortable headlines for policymakers at the Bank of England (BoE), US Federal Reserve (Fed) and European Central Bank (ECB).

CPI in major advanced economies

*Last UK inflation: December 2021
Sources: National sources, Bloomberg, QNB analysis

The policy stimulus in response to the global pandemic has been substantial over the past two years. In addition to fiscal stimulus from governments, central banks provided monetary stimulus through both interest rate cuts and asset purchases. Such strong political support was needed to avoid a much deeper and longer recession. Indeed, it has helped the main advanced economies to recover strongly in 2021 (Chart 2).

The unprecedented nature of the pandemic and the emergency stimulus policy meant the impact on the economy was uncertain. As it happens, stimulus checks sent to households in the United States and furlough programs in the three major economies have been particularly effective in supporting incomes and consumer demand. With demand outstripping supply, consumer prices (CPI) rose, driving inflation in major advanced economies.

The recent rise in energy prices is another factor pushing inflation. Energy demand was supported by stimulus measures and gradually recovered as the pandemic evolved. While energy supply was sharply reduced at the height of the pandemic and recovered more gradually, causing energy markets to tighten and prices to rise.

Energy has a large weight in the calculation of inflation in advanced economies and energy prices take time to trickle down to the economy. As a result, energy price increases over the past few months mean that inflation is likely to rise further before peaking later this year.

The UK has already raised interest rates twice, starting in December. And the Fed accelerated the reduction of its asset purchases so that interest rates could be raised from March. By contrast, a weaker recovery and lower inflation in the Eurozone means the ECB is unlikely to raise interest rates until the second half of the year.

GDP in major advanced economies

GDP in major advanced economies

Sources: International Monetary Fund, QNB analysis

The fact that inflation is so high, and likely still rising, puts monetary policymakers under pressure to aggressively tighten policy. We expect central banks to quickly remove emergency support, but be reluctant to raise rates too far too soon. Three key points support our view.

First, inflation is high now, and could increase further before reaching a peak, which could unanchor inflation expectations. Since the adoption of inflation targeting in the 1990s, central banks have focused on anchoring inflation expectations to their inflation targets. However, with inflation at such high levels and likely to rise further in the coming months, there is a growing risk that inflation expectations will lose anchor, leading to an upward spiral in wages and prices.

Therefore, central banks need to act as soon as possible to remove emergency stimulus measures to maintain their credibility in inflation targeting.

Second, historically low interest rates caused serious distortions in the financial markets. Many asset prices are influenced by the discounted cash flow (DCF) valuation method, whereby the value of future cash flows is reduced, or discounted, by the interest rate.

This means that raising interest rates too quickly could lead to a sharp drop in the price of certain assets. Therefore, central banks will need to be careful to communicate their intentions clearly and may not be able to raise rates too quickly for fear of causing financial instability.

Third, economic recovery has been rapid in 2021, but should moderate naturally in 2022 and 2023. This expected slowdown in the recovery of economic activity (GDP) should allow inflation to return to target without the need for much higher interest rates (graph 2).

Central bankers have been “talking tough” to maintain the credibility of inflation targets and ensure that inflation expectations remain anchored. They must now “walk the step” and demonstrate the action.

As a result, we could see an aggressive 50 basis point (bp) hike, or a series of 25 bp monthly hikes, from the Fed or the BoE over the next few months. However, this could easily trigger volatility in the financial markets and even cause sharp declines in the prices of certain assets.

Implicit market interest rates

Implicit market interest rates

Sources: Bloomberg, QNB analysis

We then expect a return to a more regular and gradual rise in interest rates, which is broadly in line with market expectations (graph 3). If central banks choose to raise interest rates more aggressively, there is a substantial risk that they will cause instability and volatility in financial markets.