The period since the great western banking crash of 2008 has been characterised by strong bull markets in bonds and equities. These have been assisted by large-scale interventions from the leading central banks – creating money and buying financial assets to keep interest rates low and market confidence high.
The central banks have felt able to do this because they are all required to hit targets for general inflation. For many years inflation has stayed low, thanks to plentiful supplies of labour and goods in a global market with relatively-free trade amongst the major countries. There was plenty of asset-price inflation, but market participants thought this was a good thing. Central banks thought it harmless, given the generally well-controlled prices of most goods and services.
Central bankers turn more aggressive
This year, that has changed markedly. The central banks can no longer ignore the high and rising levels of general price inflation in their economies. In the US, the EU, and UK price rises are more than double the target level – and may rise further.
The central banks have decided they need to rein-in excessive liquidity and credit. They reach for their two levers. They can stop printing money and buying bonds and they can raise the cost of credit by increasing interest rates. If they fail to act, the current goods inflation could trigger substantial pay rises – and they could face a price/wage spiral of the kind many experienced in the last century. If they act too aggressively, it could catalyse a sharp market sell-off and a recession in the real economy.
Chart 1: CPI, money supply growth, and long term rates for the US, Eurozone, and Japan
The scale of what they have done is remarkable. The big three central banks – the US, the ECB and Japan – have bought up a total of $25 trillion in financial assets, mainly the bonds issued by the governments they work for. The UK adds another £895bn, or 4%, to this huge total. This has driven interest rates down on longer-dated borrowings at the same time as they have set ultra-low short-term policy rates.
This informed the markets that they want credit to be cheap and easy. Zero became the new norm for rates during the pandemic. The two periods of maximum bond buying occurred to rescue economies from the economic fallout brought on by the banking crash of 2008, and the period of pandemic lockdowns when banks and governments saw the need to offset the large contractions in activity the health policies created.
Chart 2: Balance sheet sizes of the Fed, ECB, and Bank of Japan since 2007
It is true that China, the world’s second-largest economy, saw no need to take such action. Its central bank kept interest rates at more normal levels and did not undertake any programme of quantitative easing. It, however, presided over a large build-up of commercial and nationalised bank lending, especially to the property sector, which it is now trying to rein in to reimpose some financial discipline.
Japan has been printing money and buying bonds for longer than the other advanced countries – and is likely to carry on doing so. The low-inflation environment in Japan brought on by an ageing population with strong savings habits, seems well embedded still – even in an era of general world inflation on the rise.
US shock and awe
Proportionately, the Fed injected the most stimulus during the pandemic – and has the most elevated inflation problem as a result. It is ending all its quantitative easing this month and has embarked on a programme of rate rises to bring down inflation and slow the demand for credit. It is debating if and when it should start quantitative tightening, reducing the size of its balance sheet by selling some of the securities it bought in quantitative easing.
Chart 2: US Treasury securities held outright on the Fed’s balance sheet
The European Central Bank (ECB) is slower to alter its very-accommodative stance. It is ending its special pandemic bond-buying programme next month, only to replace those actions with more buying of bonds by its previously established Asset Purchase Programme. Its current plans envisage continuing with substantial bond buying all year, which is expected to be running at €40bn a month in the second quarter and fall to €20bn a month by year end. The ECB has said it will not consider interest rate rises until it has ended its bond buying, as it does not make a lot of sense to buy bonds to keep rates down if you are at the same time hiking short rates.
Obvious conclusions flow from these developments. Bond prices will fall as support is withdrawn and rates are increased. The EU may well see the need to speed up its adjustments, with general inflation already running above 5%. For the time being, central banks are likely to be hawkish as they try to catch up with an inflation that is much higher for longer than their forecasts. There is now a danger they will do too much, slowing the economies at the same time as the hit to real incomes from higher prices limits discretionary expenditures.
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