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Central banks give markets a dose of panic

Early last year, the main central banks were forecasting low inflation, economic recovery and the need for more stimulus. Now “transitory” inflation is less temporary than they thought.

| 8 min read

There’s nothing so dangerous as a central bank trying to catch up with an inflation spike it has allowed to grow. There is always the risk they will do too much too late – and bring the long-suffering economy to a halt instead of slowing it in a measured way.

Early last year, the main central banks were forecasting low inflation, economic recovery and the need for more stimulus to ensure GDP rose above the 2019 pre-pandemic levels. As the year advanced, we were told that there would, after all, be some above-target inflation, but this was temporary. Central bank policymakers favoured the supply-chain explanation, believing that disruptions would soon be sorted out as pandemic restrictions were lifted. This year, there is less of the “temporary” in their comments. They acknowledge that inflation is higher than forecast and will be more persistent than estimated. There is the sound of slamming stable doors after the horse has bolted.

Chart 1: CPI, Money Supply growth, and Long-Term rates in the US, Eurozone, and Japan

Japan remains the exception. Despite suffering similar supply-chain shortages and facing the same sky-high energy prices, Japanese inflation remains below the 2% target. An ageing population, caution over private credit – and the absence of any need for big wage rises – means the Bank of Japan can continue with zero interest rates and buying bonds and exchange-traded funds (ETFs) for the foreseeable future.

The Fed leads the hawks

Top of the list of central banks changing their views to a new tough stance is the US Federal Reserve (Fed), the most important of them all. The Fed now owns more than $8 trillion of securities, a mixture of Treasury bills and mortgage-backed paper, after bouts of substantial money creation to float the economy. The Fed has promised to end all bond buying this month, has embarked on a series of interest rate rises and is contemplating reductions in its pile of investments in due course.

Controlling inflation now matters more than stimulus for recovery.

The Fed’s words have changed, reflecting the clear political mood that controlling inflation now matters more than stimulus for recovery. President Joe Biden is not urging more monetary support for activity, nor is he criticising every tightening move in the way his predecessor did when inflation was much lower. Indeed, high inflation is now a threat to activity as it makes inroads into disposable incomes. People have to spend more on the basics, so they have less for the rest. There is also the threat of higher wages which, if unrestrained, could trigger a wage-price spiral on the back of too much “cheap” money.

The European Central Bank (ECB) is beginning to change its mood and language. It was complacent about inflation, thinking it was an American problem. It is true European Union (EU) inflation is still below that seen in the US. It is also true that the Euro-area economy has more Japanese characteristics than America. Euro-area inflation has now hit 5.1%, Germany has a particularly bad bout of price rises, and inflation is spreading away from being confined to the implications of energy shortages to a wider basket of goods and services.

The ECB has bought around €5 trillion of securities to keep markets liquid and bond prices high. It is still planning to continue buying substantial quantities throughout the current year. It is changing the name on the process, closing down the Pandemic Special Programme but still using the general Asset-Purchase Programme to expand its balance sheet. It may need to taper purchases more than policymakers currently think to limit the dangers of inflation.

Independence in name only

These three large central banks that affect global equity markets markedly are said to be independent, but they are very political. The Bank of Japan works closely with the government on the monetary and fiscal stimulus programmes that have shaped Japanese economic policy for many years. The Fed has a joint remit to create price stability and to ensure full employment, which gives it some flex of how to balance policy. It has always been aware of what the Treasury Secretary and President want. The chairman of the Fed reports to Congress, so he needs to go along with the majority or have some good answers if he disagrees.

ECB President Christine Lagarde is a very political central banker

The ECB is a crucial part of the architecture of an EU seeking ever-closer union. It takes decisions in the interests of holding the Eurozone together and in sympathy with the European Commission agenda. ECB President Christine Lagarde is a very political central banker, well aware of the needs of countries such as Italy that are struggling to get growth out of the economy at a time of political challenge to the European project from right-of-centre Italian political parties. There is a wish to assist Italy through support for their fiscal stimulus and avoiding undue monetary tightening.

Chart 2: Number of rate hikes priced in by the market and implied interest rates for the big 3 central banks until the end of 2022


The central banks have created a boom in bonds which has spread into a boom in various equity markets and sectors. The money they created first circulated in financial markets with obvious inflationary consequences on the prices of financial assets. That’s the sort of inflation markets like. It is now passing into the real economy as governments borrow more because the debt is cheap and have allowed commercial banks to lend more thanks to their strengthened balance sheets. People and institutions that have sold bonds to the central banks may choose to spend some of the money released. That’s the kind of inflation markets worry about.

As individuals and companies have gotten richer from asset appreciation so they have been able to afford to buy more goods and services. This adds demand pressure to prices. Central banks only know one main way of getting inflation down – that is to reverse this process and squeeze living standards.

As they throttle back on buying financial assets and raise the price of credit, people and companies lose money on assets and have less confidence to spend and less flexibility to borrow. As governments are forced to pay more for loans, they have to rein-in their wish to take out further debt. Inflation itself contributes to an economic slowdown, acting as a tax on incomes. Without a compensating pay award, people buy fewer things as the prices of the basics rise.

What next?

Markets now have to decide how bad this will get. For the time being, all we can say is the central banks are in tightening mode and it will get worse before it gets better. Our base case assumes the banks will see some success in getting inflation down from a spring peak, and that wages will not surge enough to trigger a wage/price spiral.

There will be a one-off hit to real incomes and slower growth. The downside gets worse if the banks, impatient for results, tighten too much. Then a slowdown could become a downturn. It would lead to a more abrupt and earlier collapse in inflation, but also to falling GDP and a bear market.

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Central banks give markets a dose of panic

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