The start of the tightening cycle

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The Federal Reserve, the Bank of England, and the ECB have all begun to tighten. The Fed believes that by the middle of next year, the 120 billion per month buying program will have ended. At this rate, tapering is moving faster than last time. To avoid discussions about tapering, Lagarde prefers to talk about recalibrating instead of tapering, but it amounts to the same thing. The PEPP which is roughly equivalent to the Fed’s monthly buybacks is being phased out. Meanwhile, the Bank of England is worried about the continuing high inflation rate of 4 percent and is even starting to talk about raising interest rates.  

Economy and Liquidity

Economy and liquidity (of central banks) are two communicating vessels. An economic downturn is compensated with central bank money and the moment the economy can stand on its own feet again, it is time to take money off the table. The big move by these three central banks is only possible because the economy is doing well. Central bankers are also beginning to worry for the first time about inflation and the impact of low-interest rates on financial stability. After all, until recently, inflation was a temporary phenomenon and central banks signalled that interest rates would remain low for much longer. Last week, Norway’s central bank became the first Western central bank to raise interest rates by a quarter of a percent, and Norway is not in a totally different position than many Western countries.  

Inflation is more stubborn than expected

Powell also had to admit last week that inflation was higher and more persistent than the Federal Reserve’s earlier forecasts. The Federal Open Market Committee (FOMC) is now also more uncertain about the outlook for inflation, given the wide dispersion in inflation forecasts from different members. Notable are the rapidly rising inflation expectations in the Eurozone. Based on a comparison of the German ten-year bond with a German inflation-linked bond, that inflation expectation is now above 1.6 percent. The last time inflation expectations in Germany were above 1.6 percent was in 2013. It is possible that the market fears the upcoming German coalition in which socialists and greens will spend more.  

Inflation in the pipeline

There is still a lot of inflation in the pipeline. Marine transportation costs have increased fivefold, as have European natural gas prices. Semiconductor shortages are getting bigger rather than smaller, a problem that probably won’t be solved until 2023. These are issues that a central bank would be hard-pressed to foresee. This year, the impact of weather on inflation rates appears to be very large, not to mention related to the climate crisis. The extreme drought in large parts of China and Brazil caused a shortage of water at hydropower plants, leading both countries to import massive amounts of liquefied gas, leaving nothing for Europe. In the United States, the drought is causing higher prices for agricultural commodities. Over the past forty years, each year of record drought has almost always been followed by years of normal or even above-average precipitation, but there are growing concerns that the impact of the climate crisis will create another “Dustbowl” in the United States. Central bankers do not include weather in their inflation forecasts. Moreover, food and energy are not part of core inflation. But food and energy are precisely two components where the price is often not the determinant of demand, but not of supply either. People still need to eat and the stove needs to burn. Rising energy prices and acute shortages also have a negative effect on economic growth, not the time for a central bank to raise interest rates. The dilemma for the central banker just gets bigger. 

Shortage of personnel

There is also a shortage of personnel. Although fewer people are working than before the corona crisis, it seems that many people no longer want to work. In part, this is probably the baby boomer generation who took advantage of the corona crisis to retire early. In part, fewer people are coming out of education because of the many delays caused by corona. It is also because of the strong growth in business activity, actually thanks to corona. The need for companies to adapt by innovating has worked. There are more vacancies outstanding than there are unemployed. At such a time, it is easier to demand higher wages, if only to compensate for rising prices.  

Impact of financial markets

The start of the tightening cycle will have little or no effect on rising inflation in the short term. The impact on the prices of various assets in the short term may be greater. For example, the Federal Reserve buys a large chunk of mortgage-backed securities each month, but the U.S. housing market really doesn’t need any more stimulus anyway. In Europe, too, low-interest rates have led to higher prices for financial assets, but it will take some time for this to turn around. The past shows that the first half of the tightening cycle is not so bad for the stock market at all. After all, it is a combination of good news: interest rates are still historically low, and the economy is picking up. Only in the second half of the tightening cycle do policies slow economic growth, and higher interest rates also hit valuations. The question is whether it will come to that, given the changed monetary objectives in which central bankers are embracing Keynes en masse, possibly resulting in inflation that will remain stubbornly high for a bit longer.

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