That about-turn in central bank policies, from pumping vast injections of monetary stimulus into their financial systems – over the course of the pandemic the key central banks have pumped more than $US10 trillion of liquidity into the global system – to withdrawing liquidity would represent a quite dramatic tightening of financial conditions.
Macquarie Bank research issued last week estimates more than $US2 trillion of central bank liquidity will be withdrawn over the next 18 months. If inflation rates continue to spike it could well be significantly more.
Governments, which responded to the pandemic with fiscal expansions unprecedented in the post-war era, are now winding back their spending rapidly as pandemic relief programs have been allowed to run off.
Combine the actions of the central banks and governments and you have an enormous, contractionary fiscal and monetary policy cliff. The policymakers are shifting quite abruptly from a “pedal to the metal” response to the pandemic to slamming on the brakes.
The spike in interest rates and far lower liquidity levels in prospect would be occurring in a world awash with debt. Even before the pandemic, global debt levels were high but the fiscal relief packages have swollen them further.
Streets in cities across the country have been empty during lockdown leading to stress for businesses.Credit:Getty
According to the Institute of International Finance, global debt was about $US250 trillion, or 320 per cent of global GDP, in 2018. By the September quarter of last year it was almost $US300 trillion, or 350 per cent of global GDP.
That means the finances of governments, businesses and households are now acutely sensitive to changes in interest rates and the availability of money, and it makes monetary policy decisions more difficult and sensitive than they already were.
If the Fed and its peers miscalculate in either direction – if they misread the outlook for inflation – they could do real damage to economies, businesses and individuals.
Until the pandemic and the supply chain disruptions that occurred even as consumer demand soared in developed economies, central banks were more concerned about the absence of inflation than its threat.
With exquisitely poor timing the Fed last year even changed its long-standing policy framework from trying to pre-empt inflation to, with its “Flexible Average Inflation Target” policy, responding to it after it had overshot the bank’s target rate. A few months later it has been forced to shift from encouraging an increase in inflation to fighting one.
While the extent of the leverage in the US economy makes it improbable that the Fed will be forced to do what Paul Volker did just over 40 years ago and raise US rates to 19 per cent to crush soaring inflation, it is clear that the rate at which inflation has ratcheted up and spread throughout the economy has taken the Fed and most market analysts by surprise and therefore will force it to do more than it or most market participants envisaged.
It is the dawning recognition of the extent to which the Fed is being forced to change tack that has unsettled financial markets that have become addicted to cheap liquidity. It has melted down crypto assets and savaged technology company valuations over the past week or so.
It is the dawning recognition of the extent to which the Fed is being forced to change tack that has unsettled financial markets that have become addicted to cheap liquidity.
Worst-case scenarios – the open discussion among Fed officials of four, five or even six rate rises this year and an accelerated shrinkage of the Fed’s balance sheet – aren’t, however, priced in.
Perhaps investors are still relying on the “Greenspan put,” or a conviction that in times of market turbulence the Fed will always bail them out. For nearly 35 years the Fed has reinforced that conviction in its responses to market “tantrums,” or sell-off of shares and/or spikes in bond yields.
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There is little doubt that the kind of monetary response envisaged by the worst-case scenarios for inflation and rates would provoke severe market tantrums which, because of how “financialised” modern economies now are, would also pose a threat to real economies.
It might be, of course, that the supply chain issues bedevilling the global economy and which helped to reignite inflation might be resolved this year.
The withdrawal of fiscal and monetary stimulus ought to slow economic activity. The continuance and evolution of the pandemic will also act as an economic depressant.
Inflation could abate quite naturally without draconian central bank responses. The uncertainty about the extent to which inflation is now entrenched, or how structural the supply chain issues might be, or what course of the pandemic might be only add to the sensitivity and consequence of the policy decisions and actions central banks might take this year. Their track records aren’t particularly reassuring.
