For the first time in a very long time, central bankers are coming under friendly fire as they lose control over some of the economic forces they themselves have helped to generate.
The UK economy, even by today’s general standards, is in a world of pain. This is due to a slew of reasons, from the fallout of unfinished Brexit to the ongoing impact of pandemic-induced lockdowns to the war in Ukraine and the West’s backfiring sanctions against Russia. The latest data suggest that UK growth will turn negative this quarter while inflation, already at a 40-year high of 9%, is expected to break into double figures some time soon. The high street is dying a long, slow death while manufacturing is still 2.2% smaller than it was pre-pandemic.
Bank of England “Wrong Again”
The Bank of England has warned of a looming high-inflation recession, otherwise known as “stagflation,” which threatens to push millions of families deeper into poverty and tip many cash-starved businesses into bankruptcy. The bank’s Governor Andrew Bailey recently warned of a “very real income shock” due to soaring energy prices and “apocalyptic” food prices. As the desperation grows, people are understandably looking for someone to blame. Some are pointing their finger at the Bank of England itself. In an article on Monday, the Daily Telegraph wondered how the BoE could have got it “wrong, again”, on Britain’s slide towards recession:
The bank had thought the economy would still be growing, albeit weakly. In its downgraded forecasts last month, officials predicted the UK would eke out growth of 0.1% this quarter, with a contraction only taking hold at the end of this year after October’s expected 40% rise in the household energy price cap.
Instead, analysts now think GDP will fall this quarter by between 0.5% and 0.7%. It marks a significant shift in expectations over a very short space of time.
This is not the first time the Telegraph has shone a light of the BoE’s recent failings. On May 28, Tim Wallace lambasted Andrew Bailey and the BoE for failing to heed warnings over runaway inflation. Some of those warnings had been raised internally within the bank but went unheeded:
By February 2021, the Bank’s forecasts showed the tiniest bit of inflation and predicted it would stand at 2% today.
Andy Haldane. then the Bank’s chief economist, flagged that risk prices might not behave, calling inflation “a tiger… stirred by the extraordinary events and policy actions of the past 12 months.”…
In May 2021, Haldane voted to end QE early. Looking back, he says risks to inflation were “balanced fairly and squarely to the upside,” with demand unleashed into a world of limited supply. “The laws of economic gravity had not been suspended.”
But Haldane was outvoted. “It would have been nice if I could have convinced [the] eight others around the table.”
Haldane’s was a lone voice that was drowned out by the prevailing consensus that inflation was only transitory. Once Haldane left the BoE to become chief executive of the Royal Society of Arts in June 2021, only two other BoE members ever voted to curtail QE, notes The Telegraph. A month later, the House of Lords’ Economic Affairs Committee, whose members include former BoE governor Lord Melvin King, was calling QE “a dangerous addiction” and asking the Bank to explain “why it believes higher inflation will be a short-term phenomenon.”
The Bank of England is not the only central bank being brought to task for losing control over the economy. In an article published last week in Project Syndicate, the economists Willem H Buiter and Anne C. Sibert warn that major central banks “have lost the plot when it comes to fulfilling their price-stability mandates.” Both the Federal Reserve and the Bank of England have done too little, too late to bring inflation under control, the authors argue.
“Be Happy” for Inflation
It’s worth bearing in mind that central banks have been trying their damnedest since the Global Financial Crisis to create enough inflation in order to gradually inflate away the debt, but perhaps not on the scale we are seeing today. A perfect reminder of this now somewhat inconvenient fact is an article by Reuters’ chief correspondent Balazs Koranyi from October 2021, which insisted that the return of inflation is a victory, not a defeat, for central banks.
Yes, inflation is back, and you should probably be relieved if not outright happy.
That is the verdict of the world’s top central banks, who hope they have hit the sweetspot where healthy economies see prices gently rising – but not spiralling out of control.
Backed by vast government spending, central bankers unleashed unprecedented monetary firepower in recent years to get this result. Indeed, anything less would suggest the biggest experiment in central banking in the modern era had failed.
Only Japan, which has been trying and failing to heat up prices since the 1990s, remains in the inflation doldrums.
For the other advanced economies, a rise in price pressures puts the elusive goal of unwinding ultra-easy policy within sight and at last raises the prospect that central banks – thrust into prominence during the global financial crisis – could finally step back.
The current inflation rise is not without risk, of course, but comparisons with 1970s style stagflation – a period of high inflation and unemployment combined with little to no growth – appear unfounded.
Of course, back then inflation was “just” 4.2% in the UK, 6.2% in the US and 4.1% in the EU (compared to 9%, 8.5% and 8.1% respectively in May). Now, fears are rising that central banks will not be able to tame the inflationary forces they have partly unleashed, at least not without causing huge economic pain, dislocation and destruction in the process (which some might say is actually part of the plan).
Central Banks “Failing Yet Again”
In late May, Politico‘s Opinion Editor Jamie Dettmer unleashed a salvo of criticism in his article, “Central Banks: Too Big to Fail, But Failing Yet Again“:
The price increases for goods, rent, food and energy were one-offs, so the argument ran. Simply the consequences of economies struggling to recover from the induced coma of COVID-19 lockdowns and restrictions. But now, with inflation reaching 40-year highs, and the specter of stagflation looming, central bankers are coming under sharp criticism for their complacency.
And the ferocity of the attacks on bankers, as well as the prominence, influence and political variety of their critics — ranging from left to right — all suggest this is no squall but a tempest, which may have enduring consequences for the governance of central banks.
So far, critics say that by not raising interest rates sooner, the banks have failed to act quickly, or boldly, enough to restrain surging prices, and they should have quickly turned back from quantitative easing, which was used to inject money into their economies.
Some argue that the prime pumping wasn’t necessary, that increasing domestic money supply has become an addiction for central banks since the 2008 financial crash — one they have been unable to wean themselves off.
And the criticisms are only getting rougher and louder, with some foes saying it is high time central banks were rethought, reformed and pulled back under more political control, where they could at least be held democratically accountable…
Writing in POLITICO Europe last week, former chief economist and board member of the European Central Bank (ECB) Otmar Issing fired a broadside at central banks — the ECB included — for having placed themselves “in the ‘transitory camp,’ expecting inflation to return to prior low levels via self-correction, so to speak, seeing no need for action to counter the risk of higher inflation.”
“Probably one of the biggest forecast errors made since the 1970s,” he lamented.
Of course, today’s inflationary forces are not solely being driven by central banks’ dogged application of ultra-loose monetary policy. A dizzying constellation of supply-side factors, including the shocks caused by ongoing pandemic-induced lockdowns, the war in Ukraine and the ratcheting sanctions against Russia, have played a major part, as too has corporate profiteering.
As Servaas Storm documents in his excellent article, What Is Really Causing Our Inflation: “Inflation in a Time of Corona and War”, which Yves cross posted on NC last week, corporations have used their pricing power to raise their profit margins to the highest level in 70 years:
Nominal growth of corporate profits (by 35%) during 2021 has vastly outstripped nominal increases in the compensation of employees (10%) as well as the PCE inflation rate (6.1%). Using inflation as an excuse and helped by algorithmic pricing and AI, mega-corporations are choosing to raise prices to increase their profit margins – and they hold enough market power to do so without fear of losing customers to other competitors.
Corporate profiteering is contributing to the inflation problem. According to The Wall Street Journal,nearly two out of three of the biggest US publicly traded companies had larger profit margins this year than they did in 2019, prior to the pandemic (Broughton and Francis 2021). Nearly 100 of these corporations did report profits in 2021 that are 50 percent above profit margins from 2019. Evidence from corporate earnings calls shows that CEOs are boasting about their “pricing power,” meaning the ability to raise prices without losing customers (Groundwork Collaborative 2022; Perkins 2022). Even the Chair of the Federal Reserve, Jerome Powell, has weighed in on this issue, stating that large corporations with near-monopolistic market power are “raising prices because they can.”
Given that many of the forces driving inflation, including supply chain bottlenecks, labor shortages and geopolitical tensions, are beyond the control of central banks anyway, hiking rates will probably do precious little to actually tame inflation, while at the same time exacerbating stagflationary conditions by squeezing yet more life out of the economy. It’s not as if central banks have a strong track record of taming inflation. As Storm notes tartly, a close look at the past record of monetary tightening shows that the Fed has hardly ever managed to guide the economy to a soft landing with interest rate increases.
A key reason is that small interest rate hikes do not reduce inflation (at all). It takes large interest rate hikes, but those come with massive collateral damage to the real economy—and this collateral damage might well be larger than the damage done by allowing inflation to remain high for some, while actively managing its consequences (especially in terms of the distribution of incomes).
One central bank that is finding it particularly hard to manage the consequences of high inflation is the European Central Bank, which hasn’t even begun to hike rates yet. Like many central banks, it insisted that inflation was transitory. Like many central banks, it has painted itself into a corner. Unable to raise rates persistently above the prevailing inflation rate without causing huge amounts of economic pain and market stress, all they can do is gently move rates up, which will not reduce inflation at all. As the financial analyst Lyn Alden notes in a recent newsletter, the ECB has the hardest job of all:
This was very apparent in the head of the ECB Christine Lagarde’s recent interview.
She was asked, “how will you get the balance sheet down?” while being shown the ECB balance sheet on a screen.
Chart Source: Trading Economics
She answered, “It will come. It will come. In due course, it will come.”
The interviewer paused, confused, and then asked, “…how?”
And she answered, “In due course, it will come.” And then smiled.
She offered no answer, no description, no clarification, and had rather awkward expressions throughout the exchange.
This is because, like most central banks, there is no plan. It won’t come. Sovereign debt will be monetized to whatever extent it needs to be, or it’ll collapse. And for the ECB it is particularly tough, because they have to monetize debts of specific countries more-so than other countries.
The fact the Euro Area has a monetary union but no fiscal union means that public debt is mainly held at the individual country level but each individual country does not have an individual central bank with unilateral base money creation ability. Instead they have the ECB, one of whose functions in recent years has been to monetize the sovereign debt of struggling economies on the periphery. Thanks to its purchase of trillions of euros of Euro Area sovereign bonds, including more than €750 billion of Italian bonds, the central bank has been able to keep the yields on those bonds in check.
But now that the central bank is winding down its asset buying program while talking about the possibility of hiking rates, investors are selling off peripheral bonds. As a result, the so-called “risk premium” between German and Italian 10-year yields, which is seen as a measure of stress in European markets, has surged to its highest level since May 2020, at the height of the virus crisis. In other words, markets are becoming increasingly spooked about the ability of Italy to repay its debts, given that the biggest buyer of its bonds is about to leave the market.
As CNBC notes, ECB officials’ failure to provide any details about potential measures to support highly-indebted nations is adding to investors’ jitters. On Monday, Italy’s 10-year bond yield surged to 4% — a level not seen since 2014. Yields on Spanish 10-yield bonds are also at an 8-year high while those on Portuguese and Greek bonds are at their highest level since 2017.
To compound matters, commercial banks in Europe hold individual sovereign debt as an integral part of their collateral. When the value of that debt falls, the size of the banks’ capital buffer also falls. In Italy lenders remain large holders of Italian debt despite recent efforts to diversify portfolios and soften the impact of price swings. Banks are also exposed to Italy’s economy, where higher borrowing costs will further squeeze companies and consumers already grappling with record-high energy prices.
Against this backdrop, central banks like the BoE and the ECB have become fair game, even in legacy media outlets that have spent the past two decades virtually idolizing them. For the first time in a very long time, central bankers are coming under friendly fire as they lose control over some of the economic forces they have helped to generate.
