Central banks are trapped between the twin pressures of financing growing deficits and controlling inflation.
Source - Daily Telegraph 19/06/21
One of the most surprising aspects of the pandemic is quite how resilient and adaptive major economies have proved in the face of apparent calamity.
Fast back to the dawning realisation in March last year that we had a public health emergency on our hands, and it wasn’t just fear of the disease that we had to contend with; Covid also threatened to be an off the scale economic and fiscal disaster.
Stock markets crashed, and as fears grew over how on earth governments were going to finance their lockdown strategies, bond markets nosedived.
Yet in the event, all these fears proved overblown. Beyond the most directly affected sectors – hospitality, leisure, events, non-food physical retail and international travel – the economy rapidly adjusted. New ways of operating were found that in many cases were actually better than the old ones. Almost miraculously, an array of different vaccines were developed at lightning speed, such that in most advanced economies the pandemic is now essentially beaten.
Once the decision had been taken to monetise deficits, moreover, financing furlough, the collapse in tax revenues and the humongously costly medical response to Covid proved much easier than policymakers had dared hope. There was no fiscal crisis, and fingers crossed, the long-term damage to the economy and employment looks as though it will be minimal.
Yet amid all the self-congratulation over a crisis which was, in economic terms at least, generally well managed, there is plenty of cause for concern. Almost inevitably, the policy response to any crisis ends up sowing the seeds for the next one, and that’s certainly the case with Covid; there will, unfortunately, be a mighty price to pay for the monstrous scale of the monetary and fiscal support that the pandemic triggered. A storm is coming, and judging by the inflationary signals now flashing amber almost everywhere, it may not be that far off.
Much has been made of last week’s “dot plot” of projections from the US Federal Reserve, which showed that members of the Fed’s Open Market Committee have markedly brought forward their expectations of a rise in interest rates, with a majority now thinking there will be at least two rate hikes before the end of 2023.
Bizarrely, this has been widely depicted as a “pivot” in policy, causing the dollar to strengthen, bond yields to rise and stocks heavily geared to the reflationary story to sell off. Yet even in terms of the nod nod, wink wink world of central bank messaging, it stretches credulity to see it as such. What did markets expect? It would indeed have been pretty remarkable had policymakers not somewhat brought forward their expectations of tighter policy.
The US economy is quite plainly booming again, with all the growth lost to Covid likely to be reclaimed by the end of the year. Bottlenecks and shortages are developing all over the shop, causing prices to rise sharply. The surprise rather is in the meekness of the Fed’s response.
There is still no easing back in the pace of the Fed’s asset purchase programme, while the possibility of a rate hike remains just a distant cloud on an otherwise untouched horizon of easy money. May’s surge in the inflation rate to 5pc was quickly dismissed as little more than a mirage, largely accounted for by the “base effects” of very low levels of inflation at the height of pandemic just over a year ago.
Here in Britain, the Bank of England seems equally minded to “look through” fast emerging inflationary pressures, which like the Fed, it thinks merely transitory.
Rate setters take their instruction from what happened after the financial crisis, when there was a similar spike in inflation before both the economy and prices slumped back into a semi comatose state. They would be wise to focus more on the differences this time around than the similarities.
Back then, the banking system was still essentially broken. All over the shop, balance sheets were contracting. Today the banking system is again in rude health, and is as much in expansionary mood as governments and central banks. All three canons are firing off simultaneously. The economy, in other words, will soon be running very hot indeed.
But don’t take it from me. “It is when central banks stop talking about inflation that we should be [most] concerned”, Mervyn King, former governor of the Bank of England, said a couple of weeks back. Central banks, he added, had fallen victim to a combination of political pressure to finance burgeoning deficits with asset purchases and the fashion for so-called forward guidance – essentially committing themselves not to raise interest rates too soon.
Central bank mandates had also been expanded into political spheres such as climate change, King said, weakening their de facto independence and leading to a slow response to signs of higher inflation.
He’s right. Once upon a time, the role of the central bank was to deliver low inflation, nothing more, nothing less. But now, seemingly, it’s about building a better world for all. So hand in glove with governments have they become in financing Covid-related deficits that it may actually no longer be possible to raise interest rates meaningfully without provoking a fiscal crisis.
The nub of the problem is well explained by the Office for Budget Responsibility in its last Economic and Fiscal Outlook. “Since 2009 the Bank has acquired through its Asset Purchase Facility (APF) around one-third of the total stock of UK government bonds (gilts) with a median maturity of eight years and average interest rate of 2.1pc”, the OBR observed. “It has financed these purchases by creating its own liabilities in the form of central bank reserves which, in essence, carry an overnight rate of interest, Bank Rate, which is currently 0.1pc.
“The net result has been an interest rate saving to the public sector as a whole of £17.8bn in 2021-22 from the difference between rates on gilts and Bank Rate. But these savings have also come at the expense of a significant reduction in the median maturity of the outstanding gilt stock from 11 years to less than four years”.
The upshot is that not only has the asset purchase programme considerably weakened the once admirably robust profile of the national debt, but it has made that debt highly sensitive to any change in short-term interest rates. And that goes for the economy as a whole, which is much more indebted than it used to be.
If you are coming off an interest rate of just 0.1pc, the effect on big debtors such as governments of a rise to say 3pc would be hugely more destructive than an increase of a similar order of magnitude back in the late Eighties and early Nineties, when rates were already in double digits.
Central banks face a brutal choice; let inflation rip or hike interest rates in a manner that provokes fiscal and economic crisis. No prizes for guessing which way they’ll go.
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