The Federal Reserve, the Bank of England and the ECB have all started to tighten. The Fed thinks that by the middle of next year it will have ended its 120 billion a month buying programme. At this rate, tapering will be faster than last time. To avoid discussions on tapering, Lagarde prefers to talk about recalibrating instead of tapering, but it is the same thing.
The PEPP, which is roughly equivalent in size to the Fed’s monthly buybacks, is being phased out. Meanwhile, the Bank of England is concerned about the continuing high inflation rate of 4 per cent and is even starting to talk about raising interest rates.
The economy and liquidity (of central banks) are two communicating vessels. An economic downturn is compensated with money from the central bank and the moment the economy can stand on its own two feet again, it is time to take money from the table. The big move by these three central banks is only possible because the economy is doing well. Central bankers are also, for the first time, beginning to worry about inflation and the impact of low interest rates on financial stability.
After all, until recently inflation was a temporary phenomenon and central banks signalled that interest rates would remain low for much longer. Last week, the Norwegian central bank became the first western central bank to raise interest rates by a quarter of a percent, and Norway is not in a totally different position from many western countries.
Powell, too, had to admit last week that inflation was higher and more persistent than the Federal Reserve’s earlier forecasts. The Federal Open Market Committee (FOMC) is now also more uncertain about the outlook for inflation, given the wide variation in inflation forecasts among its members. The rapidly rising inflation expectations in the eurozone are striking.
Based on a comparison of the German ten-year bund with a German inflation-linked bond, the inflation forecast is now above 1.6%. The last time inflation expectations in Germany were above 1.6 per cent was in 2013. The market may fear the upcoming German coalition in which socialists and greens will spend more money.
There is still a lot of inflation in the pipeline. Maritime transport costs have risen fivefold, as have European natural gas prices. The shortages of semiconductors are getting bigger rather than smaller, a problem that will probably not be solved until 2023. These are things that are difficult for a central bank to foresee. This year, the impact of weather on inflation rates is proving very significant, quite apart from its connection to the climate crisis.
The extreme drought in large parts of China and Brazil caused a shortage of water at hydropower plants, leading both countries to import massive amounts of liquefied gas, leaving nothing for Europe. In the United States, the drought is causing higher prices for agricultural commodities. Over the past 40 years, each year of record drought has almost always been followed by years of normal or even above-average precipitation, but there are growing concerns that the impact of the climate crisis will bring another Dust Bowl to the United States.
Central bankers do not include the weather in their inflation forecasts. Moreover, food and energy are not part of core inflation. But food and energy are two components where price is often not the determining factor for demand, but not for supply either. People have to eat and the stove has to burn. Rising energy prices and acute shortages also have a negative effect on economic growth, not the ideal moment for a central bank to raise interest rates. The dilemma for the central banker only gets bigger.
There is also a shortage of staff. Although fewer people are working than before the Covid crisis, it seems that many people no longer want to work. In part, this is probably the baby boom generation that took advantage of the health crisis to retire early. For another part, fewer people are coming out of education because of the many delays associated with Covid. It is also due to the strong growth in business activity, actually thanks to the pandemic.
The need for companies to adapt by innovating has worked. There are more vacancies than there are unemployed. At such times, it is easier to ask for higher wages, if only to compensate for rising prices.
The start of the tightening cycle will have little or no effect on rising inflation in the short term. The impact on the prices of various assets in the short term may be greater. For example, the Federal Reserve buys a large chunk of mortgage-backed securities every month, but the US housing market really does not need any more stimulation. In Europe, too, low interest rates have led to higher prices for financial assets, but it will take some time for this to turn around.
The past shows that the first half of the tightening cycle is not so bad for the stock market. After all, it is a combination of good news: interest rates are still historically low and the economy is picking up. It is only in the second half of the tightening cycle that policies slow down economic growth and higher interest rates also hit valuations. The question is whether it will come to that, given the changed monetary objectives in which central bankers are embracing Keynesianism en masse, possibly resulting in inflation remaining stubbornly high for a while longer.
Han Dieperink is an independent investor, consultant and knowledge expert for Fondsnieuws. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. He is currently active as chief commercial officer at Auréus Asset Management. Dieperink provides his analysis and commentary on the economy and markets. His contributions appear on Fondsnieuws.nl in Dutch on Tuesdays and Thursdays and often appear in English on Investment Officer Luxembourg.