Central banks need to take away the punch bowl

Overdone stimulus at the height of the pandemic, supply chain disruption and Russia’s Ukraine invasion are all fuelling spiralling inflation. Central banks need to work harder to find the economic sweet spot, writes Cormac Lucey.

Two years ago, as COVID-19 was first running rampant worldwide, our economic authorities resolved to prevent the resulting shutdowns from turning into economic depression by unleashing an unparalleled level of economic stimulus. 

In the UK, the budget deficit shot up to 15 percent of GDP. In Ireland, the deficit approached 10 percent of modified gross national income. This fiscal support was accompanied by strong monetary stimulus. 

Whereas UK broad money grew by six percent in the two years to June 2019, it rose by 22 percent in the two years to June 2021. The equivalent figures for the Eurozone were nine and 18 percent, respectively. 

While a medical nightmare was unfolding for our health services from March 2020, from an equity investor’s perspective, the 18 months that followed represented a sweet spot, as authorities stuffed economic stimulus into their economies and asset prices were the first beneficiaries. 

Since April 2020, UK stock prices (as represented by the FT 100 index) have risen by over 35 percent, while Irish shares (Iseq index) have jumped by over 40 percent. What’s bad for Main Street is often good for Wall Street. 

Now, as the COVID-19 threat recedes, this threatens to go into sharp reverse. What’s good for Main Street risks being bad for Wall Street. 

Sharp rises in inflation across the developed world are forcing central banks into withdrawing monetary stimulus and pushing interest rate increases. What lies behind this sudden burst in inflation? 

First, levels of policy stimulus were overdone in some parts of the world. Whereas the growth in two-year money supply figures referenced above was nine percent in the Eurozone and 16 percent in the UK, it was 25 percent in the US. Guess who has the biggest inflation problem? 

It is also notable that there is little or no marked inflation problem in South-East Asia, where the COVID-19-induced increase in money supply was minimal. 

Second, supply chain problems, especially energy, have contributed significantly to recent inflation readings. Eurozone inflation in the 12 months to January was 5.1 percent. Excluding energy, it would have been just 2.6 percent. 

Sharply rising energy prices are a symptom of the West shutting down conventional carbon-based sources of supply before alternative sources are ready to take up the slack. 

This shortage has been aggravated by sanctions imposed on Russia following its invasion of Ukraine. Over time, we should expect supply chain problems to be fixed and higher energy prices to be their own cure, suppressing demand and allowing for price stabilisation and reductions.

The financial sweet spot of two years ago risks becoming a sour spot as central bankers rush to restore their credibility in the face of ever-higher inflation readings. 

Jerome Powell, Chair of the US Federal Reserve, said recently, “The [Federal Open Market] Committee is determined to take the measures necessary to restore price stability. The American economy is very strong and well-positioned to handle tighter monetary policy.’’ 

Well, over fifty years ago, the then-Chair of the Federal Reserve, William McChesney Martin, said the central bank’s job was to “take away the punch bowl just when the party gets going.”

His successors may not just have to take away the punch bowl, but also shove partygoers into a cold shower. There is a real danger that an already slowing US economy could be pushed into a recession by aggressive central bank tightening. Europe would be unlikely to escape the resulting economic fallout.