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High inflation has become the norm across the rich world. Retail inflation in the US in May stood at 8.6%, the highest since December 1981. In the euro area which consists of countries using euro as their currency, retail inflation in May was 8.1%. Controlling this decadal-high inflation has become a priority for central banks. To do this, they are doing two things – raising interest rates and carrying out quantitative tightening (QT). QT is the opposite of quantitative easing (QE), which central banks have been practising since 2008.

Ballooned out
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Ballooned out

QE involves central banks printing money and pumping it into the financial system by buying bonds. This has led to total assets of central banks going up dramatically. QT is the opposite, where central banks try to take out the money they had printed and pumped into the financial system. This can be done in two ways. One is to sell the bonds that had been bought and suck out the printed money. Second is to let the bonds mature and not reinvest the money that is repaid, leading to less money going around in the financial system and the balance sheet of the central bank shrinking. Between June and August, the US Fed plans to suck out $47.5 billion per month. Post that, the plan is to suck out $95 billion per month. The Bank of England (BOE) is letting bonds mature and not redeploying that money. The European Central Bank (ECB) has talked about ending QE early.

How does this help? When a central bank raises interest rates, they push up short-term interest rates. But pushing up short-term interest rates alone does not do enough to dampen consumer demand, and in turn, inflation. For that, long-term rates need to rise as well. QT, by taking money out of the financial system, helps in doing that.

Analysts at Morgan Stanley believe that in order to control inflation, the Federal Reserve, BOE, the ECB and the Bank of Japan, will have to shrink their balance sheets by close to $4.2 trillion by end of 2023. This will push up interest rates and, in the process, dampen consumer demand and lower inflation. Will this be enough, given that inflationary expectations have become deeply entrenched? Surveys suggest that people expect prices to keep rising at a fast pace over the next one year. So do firms which have been negatively impacted by high commodity prices. In such a scenario, the high inflation expectations can get built into salary/wage demands and prices, making it difficult for a central bank to control inflation. Typically, the way a central bank tries to handle such a situation is to convey its seriousness about controlling inflation to the world at large. But this is not happening. As economist Alan Blinder, along with his co-authors, points out in a recent research paper titled Central Bank Communication with the General Public: Promise or False Hope?: “If a central bank wants to communicate effectively with its broad public, a first step is seeing to it that at least some of its signals reach their intended recipients." The trouble is, this is not happening, given that “households and firms have a low desire to be informed about monetary policy and are relatively inattentive to news about it."

So, inflation is well-entrenched in the rich world and given that central banks might find it difficult to control it, the US and other parts of the rich world might be getting into an economic recession. As analysts at Nomura said in a recent report: “we believe a mild recession starting in Q4 2022 is now more likely."

Clearly, rich world central banks led by the US Fed, let the low-interest rate party run for too long. In the process, the Fed forgot something that William McChesney Martin, its former chairman, once famously said; the job of the Fed was to remove the punchbowl “just when the party was really warming up".

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