While the Fed and the Bank of England change strategy, the ECB remains unmoved

The European Central Bank's headquarter in Frankfurt

By Daniel Rodríguez Asensio, a Spanish economist and strategy consultant, who’s the founder and President of think tank Acción Liberal.

At the end of last year, the leading Central Banks of the world have changed their strategy. While many among us have been saying for some time that inflation was not a temporary phenomenon, and that it had a strong monetary component, we did not foresee such decisive action, and in such short notice, by some of the leading Central Banks.

In December, the Bank of England raised its benchmark interest rate from 0.15% to 0.25%. The Fed, on its turn, revealed a roadmap involving ten interest rate hikes over the next 3 years, starting as early as 2022, when it plans 3 rate hikes. In total, rates could rise to 2.5%. It also announced a reduction in the pace of public debt purchases to 15 billion dollars a month, half of what it is currently acquiring.

The only Central Bank that remains unmoved, for the moment, has been the ECB, which only announced that in March, it would stop buying assets under its special programme for Covid19 (PEPP), while however increasing the pace of purchases under APP, the asset buying programme that already existed before the pandemic. With regard to interest rates, the ECB has not stated its intention to raise them, nor has it outlined any medium to long term path.

The causes of Central Banks changing tack

What has happened to cause the monetary landscape to change so rapidly? Several effects have triggered this succession of decisions:

First, inflation is starting to run rampant in all developed countries and, more importantly, half a year after the start of the inflationary process, there is not a single indicator suggesting it will recede in the medium-term.

Secondly, the warnings issued by financial markets are already being taken seriously by supranational and monetary bodies. Imbalances in key markets, such as real estate, combined with bubbles in equity and government bond markets indicate that the negative effects of these policies already significantly outweigh the positive ones. Authoritative voices have also warned about this recently.

And, finally, we must also bear in mind that the enormous amounts of money injected around the world are not having the desired effect in terms of economic growth, nor has it led to certain systemic economies dealing with structural imbalances.

Stagflation may be next

The United States, the Eurozone and the UK are moving towards stagflation, something which I have repeatedly warned about, and which is the worst-case scenario for global social stability. That is why central banks have acted, and why, in my opinion, they will stick to the course they have set.

The picture, therefore, has changed completely. Many are asking: What now?

It is worth starting with the effects of the rate hike on financial markets, as these are the ones that can trigger the most important consequences in the medium and long term.

A rise in rates makes government bonds more attractive, especially US bonds as they are, in principle, the safest. Therefore, equities may suffer in the coming years and the spare capacity that has remained virtually idle may be diverted to government bonds.

However, there is more. This increase in the return on risk-free assets automatically increases the required return on corporate and household debt, as this is calculated on the basis of the risk-free return, with an additional risk premium added. As a result, the cost of borrowing for households and, above all, companies, will increase, again reducing their valuation, thereby generating uncertainty about their ability to finance themselves on the markets.

Also, the scenario that is unfolding, has elements in terms of competition between central banks that must also be taken into account. Just as lower interest rates and QE government debt purchase programmes provided a competitive advantage to those who carried them out, as it depreciated their currency and stimulated exports, a rise in interest rates causes currencies to appreciate, in this case the USD and the British Pound, which in turn can be an additional generator of inflation in the Eurozone.

To explain this more in detail: Let’s say a mobile phone is imported into the Eurozone from the United States which, at the current exchange rate, is worth 1,000 euro. If the dollar appreciates (and the euro depreciates), it will now be worth more in euros, so inflationary pressures increase. Can the supposed positive effect in terms of boosting the export sector offset this? That remains to be seen. In my view, there is no such thing as a competitive devaluation.

Is a new financial crisis on the horizon?

This change in monetary policy strategy, therefore, has two elements of utmost economic importance for the medium and long term:

The first is a possible domino effect that ends up triggering a new financial crisis. The investment bubbles are there and the warnings have been abound. Now, with the rise in interest rates and the withdrawal of stimulus, we are going to witness the real financing capacity of many companies and families in the private sector. Let’s remember the 2008 financial crisis was triggered by a modest rise in interest rates by the Fed and the European Central Bank. The most vulnerable debtors – at that time, households – stopped paying their mortgages, thereby generating the domino effect that led to the biggest shock in history.

It is also true that there are more recent experiences of rate hikes. Between 2016 and 2018, the Fed timidly raised interest rates to 2.25%. Then, there was no impact in terms of defaults or availability of financial resources in the markets.

However, we must understand that at that time, the United States was growing at a rate of between 2 and 3%, and it had been doing so for 7 years without interruption. Now we are coming out of an unprecedented economic downturn (-3.5% in 2020) and the situation with the private sector is that we will need to wait and see if it can hold up.

What seems clear is that the latest moves by central banks are decisive and, in some cases – like in the case of the Bank of England – unexpected. This means that inflation fears have risen sharply and that imbalances are already noticeable. Is this going to be the trigger for a new financial crisis? We shall see. For the moment, this is only a tail risk. However, it is a very big risk, and the chance that it materializes is not insignificant.

Originally published in Spanish by Libre Mercado

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