Fast-rising inflation divides policymakers on the best way to deal with its effect. For too long, central bankers have been expected to take the decisions politicians should take to stimulate economic growth.
Ultra-light monetary policy has seen central banks buying sovereign and corporate debt to reduce the risk of a crisis with crushing bond prices as markets lose faith in the creditworthiness of some states and corporate borrowers. At the same time, interest rates have been reduced to all-time lows, practically eliminating risk pricing as weak sovereign and corporate borrowers found it relatively easy to tap into an enormous pool of liquidity.
As usually happens when a threat to financial and economic stability becomes daunting, policymakers and market experts split up into ‘hawks’, ‘doves’ and ‘moderates’. There is no doubt that today almost all economic experts are no longer complacent about the threat of high inflation and the likelihood that it will last longer than was expected, even up to a year ago. So what are the ‘hawks’ saying?
One expert that I trust more than many others is Mohamed El-Erian, president of Queen’s College Cambridge. In an article in the Financial Times, he did not mince his words. He argued: “The key message coming out of recent meetings of central bank policymakers is that inflation is higher and more persistent than expected – and the risk to their projections are tilted to an ever-greater rate of price rises.”
El-Erian believes that the go-slow approach of the ECB will force it to tighten more this year than it would have done otherwise. The ECB is the most cautious of central banks fearing that if it raises interest rates too suddenly, it will create a ‘financial accident’.
Joachim Fels, a global economic adviser at bond investing group Pimco, says that “easing net asset purchases and raising interest rates increases the risk of financial accidents, especially as debt levels have surged during the pandemic”.
Those who argue that central banks in the last decade have gone far beyond achieving their primary objective of ensuring price stability are right. Politicians today expect central banks to promote economic growth by propping up economic operators in the public and private sectors by providing them with easy money. But the chickens will inevitably come home to roost.
The big dilemma that central banks face is how to deal with the collateral damage caused by what many consider inevitable hikes in interest rates
Ludovic Colin, a senior portfolio manager at Vontobel Asset Management, argues: “The ECB has had many plans to create inflation (when EU economies faced the risks of deflation), but zero plans of what to do if they succeeded. The euro area as a whole can withstand higher yields. The problem we have is how fast you get to it. For the ECB, this is going to be like trying to land a massive jumbo jet in a storm without crashing.”
The big dilemma that central banks face is how to deal with the collateral damage caused by what many consider inevitable hikes in interest rates. For the past decades, economically weak countries have indulged in increasing their debt mountains to avoid deep recessions. They have even guaranteed corporate debt without sufficient scrutiny of the viability of some economic operators. This has saved jobs and kept many corporates buoyant, especially during the pandemic. But the cost is high.
El-Erian warns that “it took way too long for the Fed and the ECB to correct their misreading of price increases. The additional difficulties this poses are now being compounded by unnecessary delays in altering what remains an inexplicably uber-stimulative monetary policy stance. Stubbornly slow and partial now, the policy pivot that is sure to occur in the next few months risks considerable damage to livelihoods.”
Central Bank of Ireland’s Gabriel Makhlouf is one of the ‘moderates’ in the Frankfurt-based ECB governing council. He is less pessimistic about the possible effects of delays in raising interest rates. He writes off recent financial markets nervousness about the impact of fast-rising inflation on financial assets prices. He insists that the ECB is unlikely to raise interest rates in June as the financial markets expect policymakers to be careful to avoid “killing the recovery”.
Makhlouf rightly concludes that record inflation was “impacting on households and businesses in ways they do not want, and no one wants. We also do not want to kill off the recovery”.
Financial markets are not passive listeners to what economic experts say. If markets lose faith in politicians and policymakers grip on inflation we might see a sell-off of financial assets that could spark the next economic crisis.