The monetary policy tightrope

In my March 10 commentary, I explored the impacts of the situation in Ukraine on ongoing global pricing pressures, growth, and monetary policy. The events of the day have thrust central bankers into the one place they don’t like to be: The spotlight.

With demand booming, production working hard to recover and persistent supply chain disruptions, there are concerns that soaring prices will cut into consumers’ wealth and ability to spend and herald a more difficult planning environment for companies going forward. Will inflation throw this recovery off? 

EDC Economics believes that as the pandemic loosens its grip, helping to alleviate supply constraints and leading to a rotation in spending back toward “experiences,” or services, inflation will cool.

Of course, the situation in Ukraine is a risk, as are looming labour disputes, border blockades and climate-related events, like the wildfires and flooding last year in British Columbia. But, as economists are fond of saying, and as you’ve heard here many times, the best cure for high prices is usually high prices. 

The more immediate concern comes from how central banks might respond to inflation, or even from what central bankers might do in order to prevent inflationary expectations from taking hold.

G7 central banks are keeping a very close eye on the risk of falling into an inflationary cycle. Many have begun taking steps into a new monetary policy regime by either ending, or announcing the end, of quantitative-easing (QE) programs, while allowing maturing assets to gently runoff their balance sheets. The Bank of Canada, the Bank of England, and now the U.S. Federal Reserve, have started raising interest rates, for the first time since 2018.

But while central bankers may have stopped filling the proverbial punchbowl, the real test for markets will come when officials turn on the lights and start calling cabs for their guests. While interest rate liftoff has technically begun, rates are still very much accommodative. The move into a more contractionary rate environment and an active shrinking of central bank balance sheets through asset sales, known as quantitative tightening, won’t be without consequence; especially if they go too far, too fast.

Up to now, cheap money has supported increased government borrowing, with U.S. public debt jumping from 60% of gross domestic product (GDP) in 2007 to well over 100% today, as an example. It’s underpinned historic stock market valuations and abundant credit to the private sector.

Since the collapse of Lehman Brothers, we’ve seen more than 1,000 global interest rate cuts, and central banks have injected more than $23 trillion into the system through various QE measures. Any abrupt changes to that could be painful, hitting equity, credit and even housing markets in some countries, taking the shine off certain commodities and impacting global currency stability. 

There’s also a very real concern that higher real yields will lead to higher borrowing costs and make more risky assets relatively less attractive. This could expose overleveraged companies who’ve spent the last number of years loading up on unproductive debt, beyond what’s sustainable. If a rising tide lifts all boats, it’s only when the tide goes out, as the inimitable Warren Buffet famously said, that we discover who’s been swimming without shorts.

On the international side, monetary tightening in advanced economies could also reverse capital flows into emerging markets, many of whom themselves have been testing larger budget deficits and unconventional monetary policies. 

Governments and companies in low- and medium-income countries issued US$300 billion worth of bonds each year in 2020 and 2021, up more than 30% on pre-pandemic levels.

If the 2008 global financial crisis was an effect of our collective response to the 2001 recession-that-wasn’t, as many say it was, then consider the potential scale of any consequence to the extraordinary stimulus we’ve been pumping into the global financial system over the last little while. 

The bottom line?

The world’s central bankers face a terrible conundrum. Fall behind the inflation curve and risk allowing prices to spiral out of control. Move too aggressively, and risk a “taper tantrum” similar to, or worse than, the one we experienced in 2013. 

Fortunately, economic growth is booming. In fact, the strength of the global economy is actually at the root of many of the stresses we’re experiencing today. For now, we believe that this growth allows central banks some margin for error. But with new risk events seemingly a daily feature, that margin has narrowed considerably. Let’s hope that central bankers maintain their sure footing in the glare of the world’s spotlight.

EDC Economics welcomes feedback, over-the-top praise and other emotional outbursts. If you have ideas for topics that you’d like us to explore, please send them our way and we’ll do our best to cover them.