“If I had made a long list last year of the main challenges facing the global economy, high inflation would not have helped,” said Bank for International Settlements (BIS) chief Agustín Carstens. recently on† Should he repeat that exercise now, the currency depreciation would be at the top of the list, circled in red, underlined three times, with four exclamation points.
That’s what investors think too. On Thursday, the US stock market experienced its worst trade of the year, the day after the Federal Reserve raised interest rates by the largest rise in 22 years. Investors fear that the central bank will step on the pedal too hard, causing a recession to break out. The companies in which they have invested their money would then earn less.
It’s a widespread fear. Nearly 60 percent of developed economies have an inflation rate of more than 5 percent. It is therefore all hands on deck at central banks, whose task is to guarantee price stability. In most industrialized countries this amounts to an inflation of 2 percent per year. Miles away, because inflation in the eurozone was 7.5 percent in April, in the US it was 8.4 percent a month earlier.
What arsenal do central banks have to offer resistance? How should they deploy their weapons, and what are the possible consequences? A dive into the world of monetary policy.
The weapon of choice
The most well-known instrument of central bankers to steer the economy is the policy rate. If inflation is higher than desired, they make it more expensive for banks to borrow money from them. The banks, in turn, are passing this on to the rest of the economy in more expensive loans for citizens and businesses. Higher interest rates discourage investment and ease labor shortages, according to the central bankers’ handbook. Employees then moderate their wage demands, because there are more applicants for their jobs. As a result, companies need to pass on these costs less in their prices. That should lead to lower inflation.
It will come as no surprise that central banks are now working on higher interest rates. The Bank of England raised its key interest rate to 1 percent on Thursday, the highest level in 13 years. A day earlier, the Federal Reserve in the United States signed its second rate hike this year, to a range of 0.75 to 1 percent. The European Central Bank (ECB) is gearing up to raise interest rates in July for the first time since 2011.
Higher interest rates will not make central banks popular, acknowledges BIS director Agustín Carstens, who believes that households, companies, investors and governments have become too accustomed to low interest rates. Yes, monetary policy tightening comes with short-term costs, such as reduced economic growth and employment. But that’s the price central banks have to pay to avoid even greater costs in the future. It’s an investment in their credibility.”
It signifies no less than the end of an era of zero interest, when savings accounts no longer yielded anything and it was even free for many governments and companies to borrow.
Why was that necessary again?
Over the past decade, central banks of major developed economies have pushed interest rates to zero because they faced the opposite problem during that period as they do today: monetary depreciation was chronically low at the time. Various explanations have been proposed for this, including demographic developments and globalisation.
Central banks prefer a little inflation to no inflation. It provides a buffer against deflation, a fall in the general price level, causing consumers to postpone their purchases and the economy can come to a complete standstill. Another reason is that without inflation it is difficult for countries, companies and sectors in difficulty to become competitive again. The logical solution to lower wages is not possible in most labor markets.
Central banks therefore lowered interest rates to fuel inflation. As a result, they collided with the zero limit over time. The interest rate weapon had lost all its gunpowder. In the eurozone, for example, interest rates already reached zero in 2013. To further influence the price of money, monetary policymakers had to think creatively. And so they reached for another knob to turn: the money press.
The weapon of second choice
Central banks went to war with their balance sheets by buying government and corporate debt on a large scale – in their imagination they printed tons of banknotes for that, hence the money press. A simple example illustrates how this leads to lower interest rates. Suppose a country issues a 100 euro bond with a ten year maturity and a 5 euro coupon. The annual return for the investor is then 5 percent. If a central bank buys this bond for 102 euros, the effective yield falls to 4.7 percent. Although the coupon remains the same, the new owner will only receive 100 euros back when he has paid more for it.
The interest on, say, mortgages and business loans is often linked to the interest paid by the government. By intervening on a large scale in the bond market, central banks can influence market interest rates throughout the economy. The more bonds the central bank loads on its balance sheet, the more it depresses interest rates. The hope, again: more activity, more wage demands, more inflation. The relationship between cause and effect is a lot more unclear here than with a straightforward interest rate change, says ABN Amro economist Bill Diviney. ‘The latter is much more powerful and direct than throwing the central bank balance sheet into battle. If the policy interest rate changes, you will immediately see this in the mortgage interest rates, for example. There is more delay and noise in that relationship when building up or reducing the balance.’
“Central banks say that using their balance sheets is an important instrument for steering interest, but the truth is that we don’t really know to what extent that is correct,” said Frederik Ducrozet, central bank watcher at Pictet Wealth Management. There are a few estimates, including one from the ECB from 2019. At the time, the central bank estimated that the interest on ten-year bonds of euro countries was almost one percentage point lower than it would otherwise have been due to the debt purchase.
A lot of money, little result?
Although the balance sheets of central banks have gone through the roof due to all the buying, the hoped-for increase in inflation has not materialized. Nevertheless, the enthusiasm of monetary policymakers has remained strong over the years. With the arrival of corona, there were even special versions to help the economies through this difficult period. Since the start of the pandemic alone, the central banks of the G7, the seven most influential industrialized nations, have collectively loaded more than $8,000 billion in debt on their balance sheets, Bloomberg calculated.
It is sometimes difficult to comprehend how much money has been printed. The ECB alone today has a bond portfolio of more than 4,900 billion eurosan amount for which President Christine Lagarde could buy Amazon, Alphabet (Google), Microsoft, IBM and Coca-Cola on the stock exchange, and still have enough spare change.
After the explosion the implosion?
Now that inflation must suddenly be discouraged, instead of encouraged, the question arises what exactly should be done with all those bonds. If buying leads to lower interest rates, selling should have the opposite effect. Bloomberg news agency expects G7 balance sheets to shrink by a total of $410 billion this year. The Bank of England had a first by not reinvesting in March in a government bond that had reached maturity. As a result, the balance sheet of about 870 billion pounds became 28 billion pounds lighter.
The UK will soon be followed by the US. From June, the Federal Reserve will reduce its bond portfolio and therefore its balance sheet total by up to $95 billion per month. In a year’s time, that comes down to roughly the size of the Dutch economy. The Fed estimates that the effect will be equivalent to a 25 basis point rate hike.
For the time being, the ECB is the odd one out. Instead of reducing the balance sheet, Frankfurt continues to expand it; in May with 30 billion euros, in June with 20 billion. The ECB is likely to maintain investments until at least the end of this year. The last drop of ink is not yet out of the barrel here, as the ECB will reinvest in maturing investments during that period.
Why is Frankfurt so reserved?
‘Christine Lagarde and co want to maintain their credibility in the financial markets,’ explains Pictet economist Frederik Ducrozet. ‘The ECB has mapped out a clear roadmap and wants to stick to it. In fact, with her statements about future policy, Lagarde is already talking market interest rates higher. Financial markets are already calculating that interest rates will rise.’ This week, the yield on German 10-year bonds rose above the 1 percent mark for the first time since 2015.
Central bankers traditionally swear by restraint when uncertainty is high, says Ducrozet. ‘It’s a popular saying in these circles: when you go into a dark room, it’s best to do it in small steps, so that you don’t suddenly crash into a wall. The ECB is therefore not in such a hurry to reduce its balance sheet. It wants to avoid shocks that are too big and not trigger a recession, because then it will be very difficult to raise interest rates again.’