In Short | Market rates rise on inflation fears
Market rates have moved sharply higher amid concerns over persistently high energy prices and rising consumer price inflation. Norges Bank kept the policy rate unchanged yesterday but signalled forthcoming rate hike(s). The lessons from the 1970s suggest that central banks will prioritise bringing inflation down, even if unemployment were to increase.
Higher market rates
Even ahead of Norges Bank’s policy meeting, market rates had already risen markedly on fears of accelerating inflation triggered by the war in the Middle East. Norway’s 5‑year swap rate is now at its highest level since 2008.
Norges Bank signals rate hike(s)
As expected, Norges Bank kept the policy rate unchanged at 4 percent at this week’s meeting, but at the same time raised its interest rate forecast significantly. The new rate path points to one to two rate hikes this year, and Norges Bank states that the rate is likely to be increased at “one of the upcoming meetings”. This implies that a rate hike could come as early as May. In the central bank’s assessment, cost and price pressures in the Norwegian economy were already higher than expected even before the outbreak of the war in the Middle East. With rising energy prices on top of this, the risk increases that inflation could accelerate from an already elevated level. The duration of the conflict will be decisive, and Norges Bank notes that if energy prices remain high or rise further and contribute to higher inflation than currently projected, an even higher policy rate than currently envisaged may be required.
Focus on the inflation target
In the 1970s, the world also faced an energy crisis. At that time, central banks were primarily focused on the labour market and the risk of rising unemployment as a result of higher energy prices. Inflation and inflation expectations were therefore allowed to rise significantly, which eventually led to a sharp increase in interest rates.
Since then, most Western central banks have adopted inflation targeting, aiming to keep inflation stable around a defined target. While central banks also seek high employment and output, inflation is given the greatest weight. The inflation target and the lessons from the 1970s suggest that central banks going forward will place a clear priority on consumer price inflation when setting interest rates. It is likely that unemployment would have to rise considerably before this becomes the main concern for central banks.
This means that the longer energy prices remain elevated, the more monetary policy will need to be tightened, both in Norway and internationally, in the period ahead.