Amidst spiralling inflation, Central Banks globally have promised to take the fight with all policies at their disposal. They claim a decade of dovish measures by the ECB, BoE and the Federal Reserve have come to a close. The Great Financial Crisis of 2008 ushered in a wave of unprecedented measures by Central Banks; expansive open market operations, hastened through quantitative easing, and bank rates at levels not witnessed since the Great Depression. The coronavirus pandemic only accelerated these measures. A tsunami of quantitative easing flooded financial and consumer markets, giving birth to skyrocketing prices across most of the west and inflicting misery on households. All the while deflecting blame to anyone but themselves for the crisis at hand, Central Banks promise a hastened return to high-interest rates to stem the growing tide of inflation. A classic example of all talk, no action.
History of incompetence
The founding of the Federal Reserve intended to periodically adjust aggregate demand within the US economy to match supply. Unfortunately, recent governors have departed from the original doctrine, moving towards targeting a combination of ‘price stability’ and economic growth. Despite these two frequently at odds, the Federal Reserve has somehow failed on both fronts. Amidst a brief recession in 1930 following the Wall Street Crash, the US economy appeared to be recovering as the unemployment rate stabilised at around 4% for the better half of the turn of the century. However, following rate hikes by the Federal Reserve, contracting the money supply as the country was recovering from the mild recession, a sharp economic downturn followed – plunging the US economy into a ten-year depression.
The disastrous attacks of 9/11 prompted an excessive wave of monetary stimulus and lax policy. Slashing the bank rate to 1% and funding large budget deficits by the Bush administration accelerated the US economy into overdrive. Whilst monetary stimulus is welcome in times of economic ruin, Alan Greenspan failed to tighten with haste. Giving rise to market speculation, ultra-stimulative interest rates encouraged retail banks to offer NINJA loans to mortgage buyers, as policies by both the Federal Reserve and the government made house prices only destined to rise. These high-risk (sub-prime) bonds were packaged with prime bonds, producing the infamous mortgage-backed securities that comprised of the high returns of the sub-prime bonds and supposed low risk of the prime bonds – the perfect investment at first glance.
However, as inflation began to steadily rise amidst the Iraq War producing rising energy costs, the Federal Reserve began to sharply raise rates, leading to thousands of Americans defaulting on their low-rate mortgages – particularly those recipients of NINJA loans. What followed was a credit crunch, producing the worst financial crisis since the aforementioned Great Depression. Once again, it was the work of Central Banks in producing this mess.
Transitory?
As inflation began to gather pace in 2021, the typical government bureaucrats and Central Banks launched their ‘transitory’ rhetoric campaign. President Joe Biden and Secretary of the Treasury Janet Yellen quickly dismissed economists who warned them of the impending inflation threat, deriding them whilst repeatedly promoting this transitory lie.
“[Inflation] I believe it’s transitory”
Janet Yellen – October 2021
Eventually forced to concede in early 2022, bureaucrats then took to blaming inflation on Putin and his invasion of Ukraine. Yet, CPI inflation in the US stood at over 7% in February 2022 – just prior to the invasion. As of August 2022, CPI inflation stands at 9.4%. Even if you entirely attribute the increase in inflation over this period to the Russian invasion, statistics show that the inflation predicament had been growing long before Putin’s war quest. Even more damning for Yellen and other Putin-inflation attributors, both Brent and WTI oil prices in August 2022 are lower than at the time of the invasion. Similar denialism holds true of Andrew Bailey, the governor of the Bank of England. Despite a wave of monetary stimulus through quantitative easing, with the Federal Reserve more than doubling its balance sheets from $4 trillion to $9 trillion between 2020 and 2022, the entirety of the current inflation crisis is somehow to do with Putin. Remarkable incompetence.
The failure of Central Bankers and politicians to take responsibility for the inflation crisis is deeply concerning as the power to rectify lies firmly in their hands. The rhetoric now leans towards aggressive tightening and doing everything possible to alleviate the cost of living crisis crippling households from rocketing prices.
Tightening?
In April 2022, the Federal Reserve promised to begin shrinking its balance sheet in June, to the tune of £30 billion weekly due to inflation sharply rising over 8% at the time. This immediately raises questions about the delay in tightening. If the inflation crisis was so severe, why delay tightening for another four months? Surely, actions to curb inflation needed to be immediate if the predicament was as severe as they proclaimed. Similarly, the Federal Reserve increased the money supply much more sharply amidst the pandemic to produce the current inflation crisis. A decline in their assets would need to be at least as proportionate if not more aggressive than the initial stimulus if they were to seriously tackle the inflation crisis.
Nevertheless, the Federal Reserve still managed to fail to keep to its weak monetary tightening schedule. Despite promising to start offloading assets in June, their balance sheet remained constant over the month – hovering at just under $9 trillion between June and August. The Federal Reserve even failed to keep to its slow schedule – in spite of claims that they would fight inflation with every tool at their disposal.
Across the Atlantic, much the same feat. The Bank of England, like its younger brother, has failed to cut the balance sheets. The reasons behind this are clear. Both nations have large budget deficits – rendering an end to QE impossible, without producing a sharp rise in bond yields, and a subsequent collapse in business confidence and investment. Central Banks are the biggest purchasers of government bonds – hence the sharp rise in inflation currently as large quantities of money are created from thin air. However, if Central Banks begin offloading gilts, this will create greater downward pressure on bond prices; who would pick up the slack? Government spending needs to be financed somehow.
Hence, despite the rhetoric of monetary tightening, Central Banks have unsurprisingly failed to live up to their expectations. Had they not made governments so heavily dependent on them for financing expenditure, the withdrawal of QE and a reduction in the money supply would be far simpler.
With this said, base rates are slowly climbing across the West – albeit at a pace far too slow to seriously combat inflation. The BoE recently announced an increase in the bank rate to 1.75%, the Federal Reserve raised rates to 2.5%, and the ECB finally brought all interest rates to 0%. Inflation in all these nations is above 9%. Each of their interest rates respectively are still highly stimulative and likely to produce more inflation. In real terms, interest rates are still negative – and by a long way! When Paul Volcker successfully tamed the inflation storm raging in the 1970s, interest rates rose to above 20% – far exceeding the 14% inflation high. Real interest rates need to exceed inflation rates to be effective – otherwise, borrowing can become profitable in real terms as interest rates stand lower than inflation, giving birth to an inflationary spiral.
Whilst rates are slowly creeping upwards under the rhetoric of tightening, without a substantial increase in interest rates, these minute rate hikes will do little if anything to stop inflation from continuing to spiral out of control. Instead, the Western economies that have been addicted to cheap money for far too long will likely plunge into recession, wiping away the artificial gains in asset prices over the past decade – attributable to the large increases in the money supply. However, it remains unlikely that these prominent Central Banks will continue with interest rate hikes for this exact reason. Even as interest rates slowly climb, both the UK and US are already in recession. The consequences of a decade of cheap money are finally coming home to roost.
Ultimately, the rhetoric of aggressive tightening to fight inflation is a classic example of all talk and no action. The Federal Reserve continues to maintain its balance sheet levels despite promises to sharply reduce it, and interest rates across the West remain far too low to seriously combat the inflation storm – remaining deep in negative territory. Instead, Western economies are on track for a prolonged recession, leaving Central Banks with a choice. Do they cut rates, unleash more QE and let inflation run rampant to try and rescue the economy; or continue with raising rates, reducing the money supply, and taming inflation – all the while collapsing asset prices and plunging the Western economies into severe recession. Neither option is attractive; yet, there is no other alternative.
Free Marketeer 