VSCentral banks are getting nervous about inflation. Cost of living pressures are mounting everywhere, and the relaxed mood of last fall has been replaced by an emergency that could soon turn into panic.

In the United States, where inflation is at a four-decade high, the latest chatter on Wall Street is that the Federal Reserve will seize every opportunity to raise interest rates by the end of the year, seven times in all.

UK inflation figures are released on Wednesday, and while little change is expected this month from the 5.4% recorded in December, further increases are expected by spring. The Bank of England’s forecast should be taken with a grain of salt as it got it wrong last year, but for what it’s worth, Threadneedle Street now expects inflation to peak at just over 7%.

The Bank of England and the Fed are stubbornly waiting so long before taking measures to contain inflation. The US and UK economies are said to be overheating as the threat of the pandemic recedes, one reason being that central banks have delayed raising borrowing costs.

That may sound like a compelling argument, but the idea that the US, UK and major Eurozone economies are in the midst of a runaway boom doesn’t square with the facts. The fastest growing G7 economy over the past two years has been the United States, where output grew by 1.5% on average. The second best performing country is France, where growth has averaged less than 0.5% per year. UK production is 0.4% below its pre-pandemic level, while Germany and Italy still have some ground to catch up.

So where does inflation come from? The answer is that prices are rising faster than they were due to supply-side pressures. As economies lifted restrictions and demand returned to more normal – but not booming – conditions, serious bottlenecks emerged. Everything from computer chips to natural gas has been in short supply, driving up inflation.

That’s the explanation the Fed and the Bank of England offered last summer and fall when price pressures started to kick in, and it was broadly true. Yes, they said, interest rates should be raised from their emergency levels, but there was no great urgency as their economies were still operating below what they would have been in l absence of Covid-19. In any case, the increase in the cost of borrowing would have no impact on world energy prices.

The Bank of England had an additional problem, namely that Rishi Sunak removed some of the support that the Treasury provided to the economy last fall. In hindsight, the end of the furlough did not lead to the feared rise in unemployment, but there was no way of knowing that at the time. As a result, the Bank’s Monetary Policy Committee reacted to the Chancellor’s policy tightening by keeping interest rates lower than they otherwise might have been. As the National Institute for Economic and Social Research pointed out last week, it would have been better if the policy had gone the other way, with a less aggressive approach from Sunak providing the Bank with space to modestly increase rate.

The Bank of England and the Fed subsequently realized that price pressures were more acute than they had anticipated, while unemployment fell more rapidly. This has raised fears that workers could use the bargaining power provided by a tight labor market to obtain higher wages. If, for example, an annual inflation rate of 7.5% in the United States led to wage increases of 8%, then a wage-price spiral reminiscent of the 1970s would set in.

In the short term, inflationary pressures are expected to persist. The first three months of 2022 will echo last summer as restrictions are lifted and economies open up. People who accumulated savings during the lockdown now have money in reserve to buy a new car or book a holiday abroad. Businesses will struggle to fill vacancies, while energy costs will remain high as long as there is a threat of an invasion of Ukraine. The price of a barrel of oil is already approaching 100 dollars.

Things seem a lot trickier starting in the spring. In the UK, energy bills and taxes rise in April, and it will become clear to many workers that their wages are not keeping up with inflation. Cost increases that were initially inflationary will become deflationary as they increase costs for businesses and compress consumer purchasing power.

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In this context, the Bank of England must carefully calibrate its response (just like the Fed). Central banks clearly feel that their credibility will be at risk if they allow inflation to take hold, which means a more aggressive approach to interest rates than seemed likely at the end of last year.

There is a way for central banks to emerge with their credibility intact. If they are right to believe that inflation is currently a supply problem, only limited policy tightening will be needed. Inflation will decline with only a slight increase in unemployment. The Bank and the Fed will then be the heroes of the hour.

There is, of course, an alternative scenario in which central banks act tough while damaging their credibility, which will happen if they add to the pain already felt by their economies from excessive interest rates. The growing risk that this will quickly turn the early 2022 recovery into the early 2023 recession.

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