Price stability lower on central banks’ priority list

Published: Jan 2022

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It is clear by now that inflation in Europe and the US has risen longer and further than originally expected. The major question is therefore how the central banks should respond to this. But first a few facts.

Low growth and excessively low inflation were particular problems for central banks following the outbreak of the 2008 debt crisis. The debt crisis was solved by vast amounts of monetary and fiscal stimulus and hence even more debt accumulation. However, the combination of low growth and very low inflation makes it difficult to sustain the high debt burden – certainly when low inflation shifts to deflation. The combination of low growth, deflation and massive debt is disastrous for an economy. In order to steer clear of this, central banks sought to create a buffer of high inflation.

Inflation has now risen considerably compared to recent years. In addition, economic growth has been fairly high of late – both in Europe and the US. A positive growth rate is required as the high debt/GDP ratios mean a recession could easily trigger a credit crunch.

It is striking that newspaper articles generally only mention rate hikes as a means to combat inflation. However, it is economic weakening that depresses inflation – rather than higher interest rates. In other words, it is about raising (real) interest rates until economic growth falls back considerably. However, central banks are currently wary of hitting the monetary brakes too hard due to the risk of another credit crunch.

But what if interest rates are not raised, or only to a limited extent? Under normal circumstances, long-term interest rates are approximately at the level of nominal economic growth. There is no doubt that the soaring debt levels ensure that the economy is slowed down at a lower rate of interest than before. US growth, for example, is currently around 4%, while inflation is at around 6%. Normally, long-term interest rates would be around 10% in this case. At this point, however, ten-year interest rates are around 1.5%. This is an ultra-low (negative) level of real interest rates – to the extent where it is bound to stimulate the economy considerably, in spite of the soaring debts. It is therefore quite likely that growth will stay high, and that inflation will rise to higher levels. This may cause bond yields to rise ever more rapidly over time, which is unsustainable in combination with the aforementioned debt piles.

Changes in (real) interest rates affect economic growth with a delay of two to three quarters, while inflation is impacted after four to five quarters. This is very unfavourable in the current situation, as many economists expect inflation to decline in the period ahead. The upward inflationary pressure is largely due to corona and corona measures. The corona crisis has disrupted all manner of supply routes and created bottlenecks in production and in the labour market. However, the expectation is that the spread of corona will be curbed fairly effectively in the coming year, as a result of which the forces that are currently driving inflation will diminish in strength if not disappear. Even if this expectation comes true, however, it may well be that wage increases have ended up at far higher levels before then. This could easily trigger a wage-price spiral in a climate with ultra-loose monetary policies and exceedingly high public deficits. This will result in rising rather than declining inflation. If such a wage-price spiral is regarded as a likely risk, interest rates should be raised as soon as possible. Raising interest rates at this point in time entails the risk that the current very high inflation rate might shift to deflation after four to six quarters.

Chart 1: Rising debt levels have been a huge driver to the US economy in the past decades

Chart 1: Rising debt levels have been a huge driver to the US economy in the past decades

Source: Refinitiv Datastream/ECR Research

A warning signal from the markets

Central banks will therefore have to manoeuvre very carefully. If they keep interest rates too low, growth and inflation will stay high, with a wage-price spiral becoming far more likely. If, on the other hand, they raise interest rates too much, this could trigger another credit crunch after 12 to 18 months, from which it would be even more difficult to escape compared to the 2008-2009 period – as debts have since risen to far higher levels, and there is far less scope for monetary and fiscal stimulus at this point.

There is another complication. The US has the highest inflation risk at this point. This is clearly less the case in Japan and Europe (for the time being). This means that the Fed will have to be the first central bank to raise its rates – in a climate in which the ECB and the Bank of Japan are keeping their interest rates very low and are still creating vast amounts of surplus money. In this case, a US rate hike would attract a great deal of overseas capital, keeping asset prices high and long-term interest rates low. This means that US interest rates would have to rise considerably in order to prevent the inflow of foreign capital from counteracting the domestic economic slowdown.

Looking at various market signals in mid-December, investors do not seem overly concerned about a further rise in inflation. Gold prices are trading sideways, inflation expectations derived from the TIPS market have declined lately while investors are pricing in a mere two percentage points rate hike in the incoming two years. We draw the following conclusions from these market movements:

  • The markets believe that inflation will fall back considerably – even before a wage-price spiral is able to gain momentum.
  • The markets believe that a modest rate hike of roughly two percentage points will be enough to keep inflation low. Hence, short-term interest rates have risen of late, while long-term interest rates have declined.

We could also regard the above as a major warning for the Fed: the Fed should definitely not hit the monetary brakes hard, as this would be overdoing it, making a new credit crunch far more likely. What should the Fed do with this warning? What if the markets underestimate the amount of foreign capital flowing into the US in the event of higher interest rates? Or what if the Omicron variant is so dangerous that, for the time being, the supply side of the economy will continue to be hit more than the demand side?

A complex roadmap

Central banks have the challenge of mapping out policies in this uncertain situation. They will postpone the decision to increase interest rates as far as possible. However, this does not mean that they will mark time. For example, the major central banks are scaling back their bond purchases or will do this soon. This policy is far less aggressive compared to rate hikes.

At any rate, central banks are convinced that, in the current circumstances, deflation is disastrous for the economy. This cannot be said of inflation, especially if it does not permanently exceed 5%. It goes without saying that, when mapping out monetary policies, central banks would rather risk excessively high inflation than accept deflation.

This has important consequences for the financial markets. If, for the time being, central banks – and the Fed in particular – stayed behind the curve with regard to inflation, monetary policies would not be really tight. This would be favourable for share prices and gold prices. In addition, short-term interest rates would not rise considerably and real interest rates would stay very negative, while long-term interest rates would come under upward pressure. If, on the other hand, central banks were to crack down on higher inflation, exactly the opposite movements would likely be evident.

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