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Central banks struggle with stagflation threats

Central banks need to deal with runaway inflation before it embeds in the system. The Federal Reserve has the biggest problem of them all.

| 7 min read

In China, the authorities stepped in to stop the rout in Chinese share prices brought on by the new lockdowns and surge in Covid-19 infections. After months of taking excess speculation out of their property sector – and intervening against successful large entrepreneurial companies in the digital sector – President Xi decided he wishes to avoid a market meltdown and offered some support to financial assets. There was a strong relief rally.

We will now have to see how far the Chinese go in relaxing their money stance more generally, which is meant to be geared to keeping their inflation low as it is today and allowing a more modest growth rate than pre-Covid. They are likely to supply liquidity when needed to avoid collapse but not engage in a major reflationary boost to the economy. The underlying policies to remove “excess” and transfer more activity to nationalised enterprises will remain.

In the advanced countries, the fast recovery of equity markets at the end of March 2020 occurred well before we could see the end to lockdowns or could be sure vaccines and treatments would ride to our rescue for Covid-19. It was triggered by the spectacular response of the Fed agreeing to create as much as it took to avoid a banking meltdown and see off the cash crunch that had gripped markets.

The European Central Bank (ECB) and others then followed them. Today the central banks do not have the same scope to drive down rates and expand liquidity in the face of the big hit to real incomes that comes from the energy and food price rises, nor to reassure against the background of a war in Eastern Europe.

Their task has got much more difficult

The inflation they said would be temporary and modest has turned out to be much higher and longer lasting than forecast. The economies that were growing strongly on the back of an end to lockdowns in most of the advanced world will be slowed by the price rises and supply shocks we are experiencing at exactly the time when the central banks want to rein in money and credit to control the inflation.

Last week we saw the ECB trim a bit of its new-found austerity before any of it had been implemented, aware of the damage to output and confidence caused on their doorstep by the invasion. This week we have seen the Bank of England think better of a 50-basis-point increase in interest rates, but press on with a 25bp rise, the third in its series. The Fed has, at last, ended its creation of more dollars long after a substantial inflation has set in. The Fed too settled for a 25bp rise to get it started on a path to rectitude.

The Fed has turned very hawkish about inflation.

At the start of 2021 it saw no inflationary problems on the horizon. Now it sees a fast and worrying inflation in their rear-view mirror which has come to dominate their meetings and thinking. It has hiked its view of inflation this year from 2.6% to 4.3% and lowered their growth forecast from 4% to 2.8%. It is responding to the big change in political mood by the administration and both parties in Congress that inflation is public enemy number one and more must be done to contain it.

The Fed now thinks the US economy is robust enough and growing fast enough to avoid recession whilst they tighten. They see the need to reduce credit growth and demand to ease the supply bottlenecks. They foresee a continuing tight labour market with the risk of inflationary wage rises.

Banks behind the real economy

The main advanced country central banks, with exception of the Bank of Japan, have got well behind the real economy on prices and are belatedly trying to catch up. They claim they will be data driven, so we need to think about which of the many data sets available should have most purchase on them.

Top of the list must be wages. On both sides of the Atlantic there are labour shortages, with many people who were working before Covid not available for work now. There are people apparently taking early retirement, and people moving into education and training to upgrade their skills. So far, there have been some sharp increases in the wages in categories where the shortages are most severe, including drivers, chefs, hotel staff and some agricultural workers.

The overall level of wage settlements has not risen unduly and will now be well below headline inflation all the time it is so high. The central banks can probably be reassured that we are not yet witnessing a wage/price spiral, but they should also recognise the labour market is not functioning that well and could still get dragged into more inflationary wage growth.

They try to judge how close to full capacity the economy has become.

They will look at their idea of capacity. They try to judge how close to full capacity the economy has become and regulate money policy depending on whether there is enough spare capacity or not. They will find this increasingly difficult to judge. Capacity in an advanced country can always be augmented by imports from a world with plenty of supply. Today in many areas this is no longer true, as shortages emerge at the world level and as companies and governments rush to change their suppliers to get away from Russia and other pariah states.

The central banks may form a more pessimistic view from this review, as they see continued disruption in everything from grains and cooking oils to gas and nickel. There is a danger the high energy prices will lead to the closure of more capacity in high energy using businesses, exacerbating the need to put prices up more. The central banks are unlikely to spend much time looking at money growth or even credit advances, though this could be more useful to them in judging how tight current policy is.

Challenging conditions

Central banks cannot, in these conditions, ease money a lot to reassure markets and boost asset prices as they could during the pandemic. They can avoid too much tightening if they agree that the energy and food price rises are a kind of tax, cutting demand for other things. The latest news and views from the leading central banks show they are now more aware of their cruel dilemma. Tighten too much and the slowdown could in places become a recession. Tighten too little and the inflation can embed.

For the time being, the US is going to concentrate belatedly on inflation which is bad news for interest-rate sensitive activities and better news for savers and banks. The Europeans are more divided and will take a less aggressive attitude to inflation as they worry about the impact of the war on activity and confidence. The Fed is the most hawkish with the biggest inflation problem. We will watch to see how they fare in seeking some growth with inflation coming down.

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Central banks struggle with stagflation threats

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