by Shaun Richards
Over the weekend when some of us were busy watching the sport ( athletics and cricket) and/or the music from Glastonbury the central bankers central bank entered the economic fray.
- Timely and decisive action by central banks is needed to restore low and stable inflation while limiting the hit to growth and safeguarding financial stability.
- The risk of stagflation looms over the global economy as the threat of a new inflation era coincides with a weaker outlook for growth and elevated financial vulnerabilities.
- Policymakers must press ahead with reforms to support long-term growth and lay the groundwork for more normal fiscal and monetary policy settings.
The last point is especially ominous for those who follow the policy statements of the European Central Bank or ECB which is always calling for reform and by its repetition never happens. As to the main points it is somewhat breathtaking that any action now is described as “Timely and decisive” when in fact it takes around 18 months to work and we have high inflation now. For today’s inflation problems Carole King was on the ball back in the day.
It’s too late, baby
It’s too late now, darling
It’s too late
They are also struggling to come to terms with something we have been expecting since last year ( when some timely action could have been enacted) which is Stagflation. However they are still off the pace as I note this.
The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2022 is 0.0 percent on June 16, unchanged from June 15 after rounding. ( Atlanta Federal Reserve)
So their expectation is for no growth for the US which would follow a 1.5% ( annualised so around -0.4% as we would record it) growth in the first quarter of the year. So for what it is worth the US may be in recession, but more importantly is struggling so far this year. It also has an inflation rate that is around 9% if measured using the European system. So we have world stagflation now.
Proposed Policy Response
After the public relations effort of the headlines we do get a confession of sorts.
If relative price adjustments are persistent and higher inflation triggers second-round effects, central banks have no choice but to respond.
The translation is that if you waste a lot of time by claiming the inflationary burst is “transitory” you then have to respond. The BIS is troubled by the scale of the tightening that looks to be required.
In most countries, inflation rates are much higher than usual at the start of a tightening cycle, and real and nominal policy rates much lower, which suggests that a stronger tightening may be required to bring inflation under control.
Again they are trying to swerve the issue that inflation rates are “much higher than usual” because the central banks denied reality for so long. They do get round to it eventually sort of.
But that prescription assumes that the resulting inflation overshoot is temporary and not too large. In the light of recent experience, it is harder to argue for such a clear-cut
distinction
Also the BIS finds itself forced to face the fact that past decisions by central banks now have consequences as they asset prices ( bonds, house prices and equities) higher and in doing so encouraged more debt to be taken on.
At the same time, elevated asset prices and high debt levels mean that the output costs of tighter financial conditions could be larger than in the past.
We then get a critique of what the policy response has been so far.
Gradually raising policy rates at a pace that falls short of inflation increases means falling real interest rates. This is hard to reconcile with the need to keep inflation risks in check.
Followed by the plan looking ahead.
Given the extent of the inflationary pressure unleashed over the past year, real policy rates will need to increase significantly in order to moderate demand.
They are placing themselves firmly behind the US Federal Reserve with its latest increase in interest-rates of 0.75%. Indeed they raise the prospect of future increases being even larger.
Delaying the necessary adjustment heightens the likelihood that even larger and more costly future policy rate increases will be required, particularly if inflation becomes
entrenched in household and firm behaviour and inflation expectations.
Also I note they are looking to “moderate demand” when many countries are either contracting or near to it already which brings us on to the new central banking fantasy theory.
A Soft Landing
It is revealing that they are now thinking about this.
Most central banks are now starting to tighten policy, often in the face of high inflation. A key question is
whether they will be able to engineer a “soft landing” – ie a tightening cycle that ends without a recession.
They give a troubling prescription
A key one is that hard landings are more likely when monetary tightening is preceded by a build-up of
financial vulnerabilities.
So much of what central banks have previously been encouraging. Next comes what has been their policy for more than a decade.
Financial vulnerabilities are more likely to emerge when interest rates are low.
I suppose that is most troubling for the ECB and Bank of Japan who still have negative interest-rates.
Actually they miss out more than they include.
We do not consider the role of balance sheet, exchange rate or credit policies in policy tightening.
Plus they are not really sure what a hard landing is.
There is no standard definition of a hard landing.
Up in their Ivory Tower they cannot see those struggling below because the clouds get in the way.
Comment
We can start with something many have believed all along and the emphasis is mine.
Moreover, the unexpected inflation burst will erode to some extent the value of long-term fixed income debt
It is a tactic of the ages to pump things up basking in approval and then denying that the consequences are anything to do with you. For newer readers I can take you back more than 2 years to June 2nd 2020.
The annual rate is now 9%. On terms of economic impact then that is supposed to give us a nominal GDP growth rate also of 9% in a couple of years. Because of where we are there are all sorts or problems with applying that rule but it is grounds for those who have inflation fears.
Actually if you look at the UK now that was stunningly accurate. Actually you do not need my explanation as the official denial is clear enough.
However, surprise inflation is not a mechanism that fiscal or monetary authorities can or should rely on to control
public debt over the medium term.
There are two factors in play here. Firstly they want us to believe they will now get tough on inflation in the hope our behaviour will do some of the job for them. In a way this is already on the path to them stepping back from it if we consider the psychology at play. But even this rose tinted view of central banks has a problem with the bit below. After all they created the scenario below.
The large stocks of government debt held by central banks complicate matters. As explained in last year’s Annual Economic Report, they increase the sensitivity of
overall fiscal positions to higher rates. In effect, they transform long-term fixed income debt into debt indexed at the overnight rate (the interest rate on bank
reserves). The effect can be quite large.
This is the real reason interest-rates are so far below inflation.
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