The developed world is experiencing the highest level of inflation in 40 years.

The root causes for such a high level of inflation are in part endogenous, in part exogenous.

After the Global Financial Crisis, the US central bank “the Fed” injected very large quantities of money into the system by bailing out banks, buying Treasuries, bailing out mortgage agencies. In other words, an all-out effort to ensure that sufficient liquidity was put back into the system after it froze in 2008. It was the right thing to do since banks saddled with bad assets had stopped lending to companies and individuals: credit creation had slowed down to zero.

The Fed balance sheet increased from under USD 1 trillion to around USD 4 trillion.

In Europe, the Greek, Italian and Spanish solvability crisis led the European Central Bank (“the ECB”) to buy European government bonds and lower interest rates into negative territory at -0.5%. This happened from 2014 onwards. At the time the balance sheet was at 2 trillion and it gradually increased to 4 trillion by 2018.

The first mistake (endogenous) by both central banks was not to start removing all this extra-accommodation once the economy got better. The Fed reduced a bit down to 3.5 trillion but that was half-hearted; as far as the ECB, it did nothing because it saw inflation below the 2% target rate.

Then COVID 19 hit (exogenous shock) and governments probably committed an error in shutting down economies. In order not to put society into depression, they felt that the only way was to pay people to stay at home and help companies weather the shut-downs by putting in place various aid programs.

In addition to governments both central banks put even more money into the system; the Fed balance sheet grew to 9 trillion and the ECB’s to 8 trillion. Once the pandemic subsided, economies reopened but the legacy of the shut-downs was that production capacities had been reduced, distribution bottle-necks appeared and people had had 2 years to decide whether they wanted to go back to the same job (for many the answer was no); which in turn created an offer to demand jobs inadequacy; in a nutshell, companies had to raise salaries to convince staff to go back in the same job in some industries (hospitality, transportation, healthcare); or simply to try and attract staff that had decided to do something else altogether or retire.

Inflation appeared hard and fast: in America second-hand car prices shot up by 30%. Because chips production had been halted during the pandemic and then transportation and distribution networks had ground to a halt at the same time. Immediate consequence car plants were half idle. Similar stories abound in other industries.

Then the Ukraine-Russia war (exogenous shock) hit in February of this year pushing energy prices by 50 to 70%, and reducing fertilisers and grains supplies.

The combined effects of ample liquidity, the post-Covid re-openings and the war sent inflation to rise to around 9% on both sides of the Atlantic.

While in America the consumer and corporates benefited from the largesse of the government and can for now weather the pain; it is simply not the case in Europe. If prices do not come down fast, the US may go into a large slow-down by the end of the year and Europe by the autumn. In America it could be mild enough, in Europe a proper recession.

Facing these potential outcomes what can be the policy response?

The best way to fight price inflation is to restrict demand: in economic jargon it is called “price elasticity of demand”.

And for a central bank the best way to achieve this is to hike interest rates. By hiking interest rates, the central bank lends money to banks at more expensive terms; in turn commercial banks do the same when lending to companies or individuals. They are reducing the availability of credit. This impacts how much more a mortgage costs to service, the rate of credit cards, the cost of a new investment project for a company “cost of capital expenditure (“capex”)”.

The US Fed has already started to hike interest rates and mortgages have gone from costing 3% to 5.5%; the change in rates means that an average mortgage cost 20% of monthly income to service at the start of the year and now it is at 40%.

The second way is to reduce the balance sheet of the central bank: it stops buying government bonds, and other securities and start siphoning off the extra-liquidity by retaking the money it had lent into them; in technical terms “reverse repo”. If the central bank stops buying bonds then it disappears as a buyer of last resort and has to be replaced by economic actors in the market place. They in turn are only willing to absorb these extra-bonds (that had been ‘till then purchased by the central bank) if offered better terms; i.e. higher rates/yields on their investment.

The consequence is identical to raising interest rates directly.

What needs to be done is clear; what is not, however, is how fast and efficient the transmission mechanism is”.

How best impact the price demand elasticity?

Do rates need to be raise a little, a bit more or a lot for demand to stop, or at least reduce at these inflated prices?

From a macro-economic standpoint, how hard does the central bank go to engineer a slow-down of the economy that in turn will reduce inflation? If inflation has already become entrenched (prices for consumers get higher and higher so they demand higher wages, which in turn will push prices even higher), then the central bank needs to break the loop; and it has to raise rates quite hard, quite fast.

One can see two outcomes: a soft-landing or a recession.

If the central bank raises rates hard and fast; it is likely to succeed in clamping down inflation, but the side-effects are that the economy may decelerate too fast and create a drag leading to unemployment and recession. If it goes too tentatively and slow, it damages the economy gradually more than it damages inflation.

This is the conundrum faced by the Fed, the ECB and the BOE.
For markets it means that inflation numbers are going to be very relevant in estimating the reaction function of the central banks. One thing is sure though, the equity market highs of the summer of 2021 are unlikely to be seen again; and the volatility (sudden sharp moves) is here to remain.

Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future. Although endeavours have been made to provide accurate and timely information, we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No individual or company should act upon such information without receiving appropriate professional advice after a thorough review of their particular situation. We cannot accept responsibility for any loss as a result of acts or omissions.


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