Central banks fighting past battles

As it seems likely that interest rates in advanced nations will fall in the second half of 2024, as central banks finally get back control after they created too much money.

| 6 min read

The Federal Reserve (Fed) and the European Central Bank (ECB) have been on a wild monetary ride. Both expanded their balance sheets greatly during and after the Covid-19 pandemic. European M3 broad money growth reached more than 12% by the end of 2020. US M2 money supply grew by a quarter in early 2020, as the Fed fought to keep markets liquid. Today US money growth is falling a little, whilst European money growth is zero. This is the normal background for a boom/bust cycle.

The early movers in the world have now started to cut interest rates to avoid more of a slowdown. China has been gently slicing its rates for some time. The most recent cut took the main rate down to 3.45%. Brazil has cut by 50 basis points (bp) to 11.25%, Hungary by 100bp to 9% and Poland by 25bp to 5.75%. Turkey and Russia have had to raise interest rates to restrain inflation, whilst most of the advanced country central banks have held their higher rates for longer, as we expected.

Japan is going the other way – slowly

Japan is still in an upside-down world. The country remains desperate to boost inflation and get prices rising by 2% a year on a sustainable basis after years of low Inflation or deflation. As inflation has now picked up – and wage growth has accelerated – the Bank of Japan (BoJ) has moved its base rate from -0.1% to zero.

Still worried that it could move too far too soon – and nip the pick-up in prices in the bud – the BoJ reaffirmed a loose money policy. It may continue to buy up Japanese government bonds in similar quantities to before, though it will throttle back on purchases of corporate bonds and stop buying exchange-traded fund and real-estate investment trust shares. The BoJ confirmed it will continue to provide loans to stimulate more commercial bank lending.

The rest of the advanced world is still fighting past battles and trying to correct for past mistakes. The Fed, the ECB, the Bank of England (BoE) and others created too much money and bought too many bonds at very high prices during the pandemic and post-Covid recovery period. This helped create inflation, which had set in before the invasion of Ukraine by Russia triggered a leap upwards in energy prices.

China and Japan avoided the high inflation despite being large energy importers because they did not suddenly increase their money supply in response to the pandemic.

China and Japan avoided the high inflation despite being large energy importers because they did not suddenly increase their money supply in response to the pandemic. China did not buy bonds and Japan continued to buy similar volumes to before Covid.

In 2022-3 the central banks changed their view that the inflation would be temporary. Whilst still arguing the inflation had been caused by the war and energy and food prices, they tacitly accepted that their monetary policy was a big part of the problem. They put up base rates substantially. They stopped buying bonds. They began to run off or sell their bond holdings. This represented a major monetary tightening. As a result of these actions, inflation is now subsidising on both sides of the Atlantic.

The US has been the most aggressive, cutting its bond holdings by around $1.3 trillion so far from a mixture of sales and maturities. The ECB has been more cautious, relying on run off rather than direct sales. In 2023 the ECB/Eurosystem balance sheet contracted by €1 trillion, with the bulk of the reduction being in loans to commercial banks. These policies were designed to restrict credit in the broader economies, using a slowdown in activity to reduce pricing power by companies.

Why there has not been a bad recession?

This cycle has been unusual. In the past, large rate rises coupled with restricted credit has brought inflation down by cutting output and leading to higher unemployment. This time, labour markets have remained tighter. Many individuals who kept their jobs during lockdowns saved more which they have since been able to use to sustain their consumption. Employers have been reluctant to shed labour and vacancies have remained strong relative to numbers seeking work. As a result, wage growth has proved quite resilient – and it has taken longer to get inflation down in employment-heavy services.

The Euro-area has suffered from no growth with weak industrial activity, especially in Germany, but has not plunged into a deep recession. The US has seen good growth, despite the sharp monetary tightening. This is because the US is the main motor of the digital revolution, continuing to make big advances with its leading-edge digital retailers, phone and computer suppliers, software producers, online entertainment and social media providers.

The US Administration last year was able and willing to spend by borrowing more, boosting the federal deficit by a further $1 trillion as an offset to monetary tightening. As a result of these developments, the US has produced good growth and a large fall in inflation, whilst Europe has marked time on output whilst reducing price rises.

Despite some stickiness in wages and service inflation, it is likely official interest rates will be falling in the second half on the year in the Euro-area and the US. The latest report from the Fed points the way to official cuts in rates later this year as the market is expecting. This will be copied by other advanced countries that have not yet started cutting.

The Europeans need to move faster as their economies are weaker. Most of the inflation is now in the rear-view mirror. There is a European Parliament election in June and a US presidential election in November, so there will be pressures to think more about growth and expansion. If central banks do not cut when price rises ease, they tighten the squeeze as real interest rates go up each time inflation falls and rates stay the same.

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Central banks fighting past battles

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