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Inflation And Political Interference: 2023 Is A Minefield For Central Banks

As recession predictions abound, stakes are higher than ever for the number crunchers at the world's top central banks, who must also contend with the whims of the political class.

Inflation And Political Interference: 2023 Is A Minefield For Central Banks

The Bank Of England in London

Steve Schifferes

Some of the world’s biggest economies — and their central banks — face a tricky task this year taming inflation via higher interest rates without triggering a recession.

And whether they like it or not, the U.S. Federal Reserve, the Bank of England and other central banks are now being thrust into the center of a political debate that could threaten their independence as well as their ability to act decisively to curb rising prices.

I’ve been following and covering politics and finance for four decades as a reporter and now as an economics research fellow. I believe there are two key ways politics may interfere with central bank plans in 2023.

An inflationary challenge

High inflation is perhaps the biggest challenge facing the world economy over the coming year.

Inflation has rapidly accelerated and is now at or near its highest rate in decades in most developed economies like the U.S. and in Europe, causing living standards to stagnate or decline in many countries. This has particularly hurt the poorest people, who suffer a higher rate of inflation than the general population because they spend more of their income on food and energy.

The sharp rise in inflation caught central banks by surprise after two decades of low and stable inflation. They reacted by aggressively raising interest rates in the second half of 2022, with the Fed leading the way. The U.S. central bank lifted rates 4.25 percentage points over a six-month period, and the Bank of England, the European Central Bank and others followed in its footsteps.

Both the central banks' credibility and independence may be under threat

Their strategies seem to be working. Inflation in the U.S. has slowed, while in the UK and the eurozone, recent data suggests inflation may have peaked — although it’s still very high, at around 10% — and might start trending down.

But interest rate hikes — which are expected to continue in 2023, albeit at a slower pace — could further cloud the outlook for economic growth, which already looks grim for developed economies.

The Organization for Economic Cooperation and Development predicts that in 2023 both the U.S. and the eurozone will grow by only 0.5%, well below their historic averages, while Europe’s largest economy, Germany, will actually shrink by 0.3%. In the U.K., the Bank of England projects that the economy will continue to shrink until the middle of 2024.

Fiscal spending

That brings us to the first political problem that could upset central bank plans: government spending.

The politics is playing out in different ways. In the U.S., spending has increased substantially, most notably with the $1.2 trillion infrastructure bill signed into law in late 2021 and the $1.7 trillion budget bill passed in December.

This kind of expansionary fiscal policy, which may be in place for years, could undermine attempts by central banks like the Fed to fight inflation. As the central banks seek to reduce inflation by curbing demand, increased government spending has the opposite effect. This could force the Fed and other banks to raise rates even higher than they otherwise would have.

In Europe and the UK, governments have been forced to spend billions to subsidize the energy bills of consumers and businesses, while the economic slowdown has reduced their tax revenue, leading to soaring government deficits

Nevertheless, in the UK the Conservative government has prioritized the fight against inflation, announcing cutbacks to consumer subsidies for energy, plus higher taxes and further cuts in public spending if it wins the next general election, which is expected to take place in 2024. While these actions are deflationary, they are politically unpopular.

The Bank of England is now split on whether, or how fast, to continue to raise rates.

The cost-of-living crisis is now at the top of the public’s agenda in many developed countries

Sara Kurfeß

Central bank independence under threat

The other political problem is more existential for central banks and makes their task all the more delicate.

For the past 20 years, their independence from government interference and the setting of public inflation targets at around 2% have helped them gain credibility in fighting inflation, which stayed at historic lows for much of the 21st century.

Now both their credibility and independence may be under threat.

Central bankers, especially in Europe, are acutely aware of public concerns about how higher interest rates might stifle growth, in part because their economies have been more severely affected than the U.S. by the Ukraine war. Meanwhile, consumers are being hit by higher mortgage payments, which may tank the housing market.

At the same time, central bank efforts to persuade workers not to ask for higher wages to compensate for inflation, which would help reduce the need for more interest rate hikes, have spectacularly backfired, especially in Britain, where a wave of strikes by public-sector workers shows no sign of abating.

Long-standing political tensions over the role of the European Central Bank have been exacerbated by the election of right-wing governments in several eurozone countries.

Fears of 1970s-style stagflation — high inflation and stagnant economic growth — could become a reality

Traditionally, under the influence of Germany’s Bundesbank, the European Central Bank has worried about inflation more than other central banks. Under competing political pressures, it has moved more slowly than some other central banks to unwind its policy of low — and even negative — interest rates.

On the other side of the Atlantic, where Fed Chief Jerome Powell has rejected any attempt to mitigate his focus on inflation, political pressures may grow from both left and right, particularly if Donald Trump becomes the Republican presidential nominee. This ultimately may lead Congress or a new administration to try to change the central bank’s approach, its leadership and even its mandate.

Uncharted waters

None of this might be a problem if central bank projections of a sharp fall in inflation by the end of 2023 come to pass. But these projections are based on the belief that energy prices will continue to remain below their peak or even fall further in the coming year.

Just as in 2022, when central banks failed to grasp the inflationary threat early enough, other risks beyond their control, as well as political developments, may derail their hopes. These include an escalation of the war in Ukraine, which could raise energy prices further, more supply chain disruptions from China, and domestic pushes for higher wages.

With the cost-of-living crisis now at the top of the public’s agenda in many developed countries, the setting of interest rates has ceased to be just a technical matter and has instead become highly political. Both governments and central banks are entering uncharted waters in their attempt to curb inflation without stifling growth. If their projections prove overly optimistic, the political as well as the economic costs could be high.

All this means that the outlook for inflation is highly uncertain. And fears of 1970s-style stagflation — high inflation and stagnant economic growth — could become a reality.

Steve Schifferes, Honorary Research Fellow, City Political Economy Research Centre, City, University of London

This article is republished from The Conversation under a Creative Commons license. Read the original article. This article is part of Global Economy 2023, a series about the challenges facing the world in the year ahead.

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La Défense Or Bust? Inside The Battle To Save Europe's Largest Business District

Deep structural problems were already pushing it to breaking point. And with teleworking becoming the new normal after COVID, Paris's La Défense business district stands as a melancholic shadow of its old, buzzing self. Can it find a way to reinvent itself?

Photograph of La Défense at sunset

La Défense during sunset

Gabriel Grésillon

PARIS — The days when Khadija served copious ribs of beef and bottles of fine wine to executives in suits feel like ancient history. The restaurant, located in “Les Quatre Temps” shopping center in the La Défense district near Paris, has had to adapt to a radically new world. “We have removed all the meats that are too expensive from the menu, no one orders them anymore”, Khadija says mournfully, adding that the restaurant's clientele has shrunk a lot from its glory days.

The advent of remote work has pushed businesses in this neighborhood into a mortal crisis. “Fridays, which used to be good days for us, have become catastrophic,” Khadija says. She then goes on to list all the restaurants in the area which have permanently shuttered.

A few meters down the road, Julianna, manager at a ready-to-wear store, remembers the days when it took five people to tend to customers. “Today, two employees are enough," she says. "Our turnover has fallen by almost 60% in two years." She also lists the neighboring businesses which have closed down, from clothing and lingerie outlets to ice cream parlours. Clearly, the carnage hasn't spared anyone.

Maxime Lévy can only agree. Ten years ago, Lévy's Forestland store had to sometimes close its gates in the middle of the day to control massive crowds. “It’s becoming more and more complicated to do business here,” he admits. In front of her storefront, this hairdresser reckons her clientele has been halved since COVID. She says she is crossing her “fingers, hands, feet, everything, for business to resume soon.”

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