The glorious era of falling inflation has come to an end as we enter a concerning new cycle of spiralling prices, so what now for the global economy? Cormac Lucey looks ahead to the potential implications of tightening monetary policy and second-round psychology
Recent spikes in inflation were initially described as “transient,” and attributed generally to one-off supply chain problems. The comforting implication was that high inflation readings would swiftly retreat once supply arrangements returned to normal.
This has not come to pass, however, and successive central bank forecasts predicting inflation would soon retreat have failed to materialise. Instead, price hikes have accelerated.
The most recent inflation readings are 8.6 percent in the euro area, 9.1 percent in Ireland and 12.7 percent in the UK. These inflation rates compare to central bank base rates of a mere 1.25 percent for Sterling and 0.5 percent for the euro.
In fact, real base rates of interest have never been this low — so, have central bankers fallen behind the curve?
Whether we wish to accept it or not, the reality is that we are currently experiencing inflation regime change. Zoltan Pozsar has observed: “It’s blatantly clear that this is not an average business cycle. This is not an average inflation backdrop. And this is not an average hiking cycle.”
The post-1980s era of steadily falling inflation rates has ended. From a financial perspective, it was a glorious era as ever-falling inflation rates permitted ever-falling interest rates that spawned ever-rising asset prices.
Following an unprecedentedly large economic stimulus to combat the pandemic-induced economic slowdown, that era culminated in record stock, property, and bond prices. With the return of inflation, all of this is at risk.
The danger is that inflation expectations rise and second-round effects kick in as companies, unions and workers seek to raise their prices, not just to recoup past cost increases, but also in anticipation of future increases.
As the Bank of International Settlements noted in its recent annual report: “Ultimately, the most reliable warning indicator is signs of second-round effects, with wages responding to price pressures, and vice versa. These can be especially worrying if they go hand in hand with incipient changes in inflation psychology.”
The report also points out that “the degree to which the general price level becomes relevant for individual decisions increases with the level of inflation. When inflation rises, price changes become more similar.”
With inflation at nearly 10 percent, this danger is now very real. What can the authorities do to squeeze the inflation genie back into its bottle?
In a nutshell, central banks need to tighten monetary policy to slow down the economy. If inflation is a form of economic cancer, monetary tightening represents economic chemotherapy.
While its aim may be to treat only those parts of the economy that are diseased, however, monetary tightening risks unleashing unpleasant side effects, including recession.
The economic downturns in the US over the past 50 years were preceded by tightening monetary policy. It was the ECB’s steady raising of interest rates after July 2005, however, that finally pricked Ireland’s property and banking bubble.
As Pozsar notes: “We have never achieved a soft landing, so let’s not pretend that the fastest pace of [interest rate] hikes in a generation, and an unprecedented shrinkage of the [central bank] balance sheet, will yield one.”
In my opinion, the monetary conditions for recession are now present. Even before central bank interest rate hikes really get going, the growth of real money has turned negative in both the US and the eurozone.
And, as was stated in the March 2019 issue of the ECB Economic Bulletin, “The leading and pro-cyclical properties of real M1 with respect to real GDP in the euro area remain a robust stylised fact.”
Previous chairs of the Federal Reserve, Alan Greenspan and Ben Bernanke, drove asset prices up. Jerome Powell is driving them down, and he could keep pushing against stock price rallies until he succeeds.
Cormac Lucey is an economic commentator and lecturer at Chartered Accountants Ireland