The central bank's big bet

To make the most of the recovery and favor job creation, the Fed, the ECB, and the BoE maintained the expansionary tone of their monetary policies

(low rates and asset purchases) even though prices were (and still are) rising at rates not seen in recent decades.

Central banks are betting everything on transitory inflation that will supposedly lose momentum throughout 2022. This combination (low rates and high inflation) has led to the negative gap between interest rates and inflation (Real interest rates) touching 60-year highs in the US, while in the Eurozone it has never been so wide in its 22 years of life.

Central bankers probably know they are playing with fire by maintaining historically low-interest rates with inflation at decades highs. Keeping real interest rates (nominal rates minus inflation) in the very negative territory can generate bubbles in some asset prices, pave the way for transitory inflation to become permanent, or de-anchor inflation expectations, for example.

The last time inflation was above 6% in the US, the interest rates (federal funds) managed by the Fed were between 7 and 8% (1990). Now, with CPI at 6.2%, official interest rates are between 0 and 0.25%. In the Eurozone, inflation has exceeded 4%, and the deposit rate set by the European Central Bank is at -0.5%.

Fed officials seem to be disconnected from real economic data, which could lead to interest rate hikes that come too late to control inflation.

Not only high-yield bonds, but also stocks, housing... asset prices continue to rise. With real interest rates in historically negative territory, keeping money in a deposit or liquidity means losing purchasing power day by day. Flows are massively redirected towards riskier assets that can offer a positive nominal (but not real) return, increasing the risk of bubbles that could burst if central banks end up losing their big bet.

Risks of going behind the curve

Economists agree in a new report published in November: major central banks could be behind the inflation curve. However, their baseline scenario (the one they give the highest probability to) sees CPI moderating in 2022 naturally as the strength of the recovery 'fades' and knots in the supply chain unravel, but for now what they are seeing is a slowdown in the economy and upward pressure on prices.

Even if the transitory factors abate, the underlying trend of inflation could have turned higher from pre-pandemic levels in many countries due to several factors (energy transition, de-globalization, labor costs...). The current situation is a major challenge for central banks.

If inflation does not turn out to be transitory, central banks could be blamed (at least in part) for having kept the price of money very low at a time when demand was outstripping supply and the economy was at risk of overheating. The prestige achieved by these institutions in developed countries could deteriorate.

There is a risk that the Fed's new inflation framework will be too slow to act on price pressures. This delay could lead to much greater disruption to economic and financial activity than would be the case if the Fed finally acted.

Jerome Powell, Fed Chairman, has repeatedly defended the central bank's lax stance by arguing that raising rates will not get ships into port any sooner (it will not unclog the supply chain). However, it would also not be unreasonable to think that tighter monetary policy might have held back demand somewhat, and therefore the pressure that has 'broken' the chain would not have been so overwhelming. Consumer spending and investment would have picked up more moderately and progressively, allowing supply to keep pace with demand. Growth would indeed have been lower in 2021, but perhaps more sustainable in the medium term and, above all, generating lower inflation.

But today there does not seem to be the fear of inflation that there was in the past. Major central banks in developed countries are showing a greater degree of tolerance for inflation rebounds than they used to. However, lack of policy action amid high inflation increases the risk that a wage-price spiral will re-emerge or that long-term inflation expectations will be unleashed, leading to the undesirable adverse outcome of persistently high inflation.

In that case, controlling inflation would require aggressive monetary tightening, which could precipitate a recession. If expectations become unanchored (agents stop believing that inflation will be under control in the medium term); price increases, now concentrated in a few products and sectors, begin to permeate the rest of the basket of goods and services (something that is already happening); and wages begin to respond to this new reality, central banking would have to act to regain control of the situation.

In the 1980s, the Fed and Paul Volcker had to bring official rates up to five points above inflation (very positive real interest rates, the opposite of today). Such a move today would have unpredictable consequences. Very high stock market valuations and debt levels that are only sustainable with low interest rates are among the most important dangers. A major stock market crash, public debt crisis, sharp price corrections in the real estate market (interest rates are the kryptonite of this market) ... readjustment would be necessary, but at the same time very painful.

Nevertheless, there are central banks that are still in a more delicate position. In emerging countries they face difficult policy dilemmas from a financial stability perspective, says Nomura. If they remain behind the curve, this could generate even higher inflation (inflation expectations are not well anchored in emerging markets), resulting in a prolonged period of negative real interest rates, which in turn could further inflate financial asset prices and drive demand for real assets such as land, housing, commodities and cryptocurrencies as a hedge against inflation, while acting as a tax on savers.

In addition, these central banks also depend on whether the Fed starts taking action to control inflation, that could trigger corrections in asset prices, capital flight from emerging markets, exposing their balance of payments vulnerabilities. A rapid rise in credit costs would generate significant debt repayment problems, which could trigger more defaults and credit events around the world.

Pin It