During the pandemic, critics were most happy to support what the central banks did on both sides of the Atlantic and in Japan to slash interest rates, make large amounts of cash available, and to sustain what activity they could as lockdowns limited economic activity. This has now changed.
Last year, some commentators saw the inflation dangers, became more concerned about the rising price threat – and thought central banks continued creating large sums of money for longer than needed, given the general strength of the recovery. Today, we face a destructive war and the impact of wide-ranging sanctions. There are now no easy or obvious answers for those in charge of monetary policy.
Twin pressures hit consumers
Many parts of the advanced world face the twin pressures of a slowdown as consumer incomes are squeezed by rising prices compounded by issues surrounding badly-disrupted supplies of commodities and products that are subject to shortages due to issues in their supply chain. We will have to live with the threat of higher inflation for longer.
However, do too little to control prices and the inflation could embed, making it more likely the central banks will be forced into tougher action carrying the risk of recession. Do too much to control prices – at a time when physical interruptions to supply and temporary distortions to trade flow from the sanctions – and the central banks will slow economies too much at a time of tension. They need to find that balance point that allows gentle downward pressures on prices later this year, with some support to activity and to their commercial banking systems to get through the crisis.
The three major advanced-country central banks – the Federal Reserve (Fed), the European Central Bank (ECB) and the Bank of Japan (BoJ) – all start from different positions and need different approaches.
The BoJ still has no major inflation problem. Indeed, as for many years, it is still puzzling over how to get its measure of Japanese inflation to its 2% target, despite the obvious surge in energy prices that hit Japan as much as anywhere else.
The Fed has a substantial inflation problem after two years of significant expansion of the supply of money and very low interest rates. The economy is still expanding well, thanks to substantial past stimulus.
The BoJ can and probably will continue to create substantial new money and keep its rates at zero.
The ECB has considerably more inflation than it wants, or is used to, but is faced with a more concentrated shock from the war in Ukraine. This impacts European banks with elevated Russian exposure and has resulted in a substantial migration of people at a time when the continent’s economy is facing difficulties in key areas such as the motor industry, with supply-chains pinch and investment needed into the rapid transition to very different products.
The BoJ can and probably will continue to create substantial new money and keep its rates at zero. It will get some activity boost from the gradual unlocking of the economy after prolonged Covid-19 dislocation that has lasted longer than in most other western economies.
ECB accelerates end of asset purchases
Yesterday, the ECB set out its latest thinking. The central bank will need to ensure sufficient liquidity for the European commercial banks against this challenging backdrop. Whilst most of them are strongly capitalised and can take some hit from writing off or writing down Russian assets, any bank with undue exposure to Russia/Belarus now has a problem.
Greece is singled out for special mention.
The ECB stressed the relatively small size of the Russian economy and said it would continue its targeted longer-term refinancing operations (TLTRO) programme until June. TLTRO offers longer-term loans to banks at attractive rates. It will also extend euro liquidity to other central banks until 15 January 2023 and is looking to see how it can help the authorities of Ukraine and the refugees in European Union (EU) countries access money and facilities. Greece is singled out for special mention, where targeted bond buying could aid liquidity if financial conditions in its fragile economy become too tight.
The ECB is clearly worried by the scale of inflation, so it has also decided to change its stance on quantitative easing. It has now decided to cut QE to €20bn a month by June. It acknowledges huge uncertainties and wishes to stay flexible thereafter, with the possibility that these asset purchases end or continue. It has also confirmed interest-rate rises will start “sometime after” the ending of QE, adding another uncertainty about when rate rises will occur. This represents some tightening of its view, probably influenced by the much higher inflation numbers.
All about data
Decisions will be data driven and the ECB says the crucial data will be its forecasts of medium-term inflation. It appears to have given up tackling short-term inflation, which may get worse depending on energy prices and other supply dislocations. The central bank takes some comfort from the fact that, in the final quarter of last year, wage increases remained low. It is, however, watching wage settlements to see if they match price rises – a warning sign that would require tougher action.
The ECB stands ready to help the EU raise more money in bond markets for a further EU-level fiscal stimulus but acknowledges that has to be settled by the European Council. The ECB would also lean against any member state or EU fiscal stimulus that threatened higher prices in their medium-term forecasts.
The Fed has most need of counter-inflationary action. The US economy is more insulated from the stresses resulting from the war in Ukraine, with enough domestic gas for home consumption and some left over for export at high prices. Activity is still strong – and the labour market remains tight. The Fed is likely to continue with a careful pace of rate rises reflecting the need to do more to curb inflation, whilst keeping a close watch on the deflationary impact of higher world commodity and energy prices.
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