Inflation (3) Central Banks

Inflation is always a monetary phenomenon. Prices of goods and assets go up and down relative to each other due to changes in supply and demand, but an overall increase in the price level has to be funded by the central bank increasing the supply of money.

Since the GFC in 2008/9, the Federal Reserve has massively expanded the money supply, first by keeping interest rates low (near zero) and second by quantitative easing. The Fed brought roughly 3.5 trillion assets between 2008 and 2014 (mostly Treasuries). It has never been able to roll this quantitative easing back and now holds $9 trillion on its balance sheet. Central banks throughout the western world followed this example.

Inflation of a currency does not always feed through evenly. When central banks massively inflated their money supply during the golden season, the inflation did not push through to consumer goods, due to the enormous supply of consumer goods manufactured in China. Instead, it flowed into a massive increase in the prices of financial assets, particularly share prices. The boom in share prices increased the wealth of the wealth in a big way. Ordinary people did not complain too much because cheap consumer goods deadened their economic pain.

Lack of inflation allowed central banks to keep interest rates low for over a decade, which enabled households and businesses to increase their borrowing. Governments also borrowed heavily to deal with Covid. The consequence of low-interest rates is that households, businesses and governments are now all heavily indebted.

A major outcome of getting inflation under control in the 1990s was that price stability became the target for central banks all around the world. This policy emphasis assisted the development of a trading system based on the US dollar. The guarantee of price stability made it safe for businesses and foreign governments to keep their foreign reserves in US Treasuries because they would not be eaten away by inflation. China took advantage of this situation to hold large reserves in US Treasuries. Foreigners currently own $US33 trillion of US financial securities and short-term assets. Unfortunately, inflation is now roaring back into the world economy again, undermining the guarantee of price stability.

The constraints on price inflation have now come off and consumers all over the world are facing serious inflation that is eroding their living standards. Normally, when inflation gets out of control, central banks tighten the money supply by increasing interest rates to dampen demand and take the heat out of their economy. In the current situation, rolling back quantitative easing by selling treasuries and the other assets that central banks have purchased would be part of the solution.

Increased interest rates are considered to be the standard cure for price inflation, but the Federal Reserve and central banks around the western world face a serious dilemma, as the traditional medicine could be quite painful.

• Near-zero interest rates allowed governments to rapidly expand their debt without facing any extra interest burden. If central banks push up interest rates, governments will have to find money to cover their interest bill. They will not be able to borrow so easily, so their budgets will have to be more constrained, at a time when there are growing demands for more government spending.

• Interest is a significant cost for all businesses, so an increase in interest rates will up the cost of production for them, at a time when they are already struggling to deal with the increased costs described in the previous post.

• Rising interest rates will put pressure on households with big mortgages and other types of debt. They will cut back their spending at a time when the world economy is only just starting to recover from the Covid shutdowns.

• If governments push up interest rates to control inflation, they will hurt both businesses and households when the recovery from the covid recession is still very weak.

• Another big problem is that the share price boom and rapid increases in property prices have been driven by a long period of low interest rates. If interest rates are increased sharply, financial markets could collapse with shocks spreading throughout the economy.

• The combination of high debt levels and raised interest rates will make it difficult for governments to spend their way out of any recession.

• Rising interest rates reduce bond values. Through QE, the European Central Bank (ECB) and the Bank of Japan have bond portfolios, which have already wiped out their equity, playing havoc with their balance sheets. Like many other central banks, the ECB is technically bankrupt and needs a massive, systematic recapitalisation, but there is no institutional pathway for a capital injection to occur.

• The United States has a couple of extra problems that will make it difficult for the Federal Reserve to deal with rising price inflation.

  • Every economy needs institutions that shift money from those who want to save to those who need to borrow. This is a relatively straightforward process that does not need a huge number of institutions. Through hyper-financialisation and securitisation of debt, the US banking system has built a massive superstructure of debt, derivatives and other dodgy financial instruments sitting on top of it, weighing it down. If too much pressure comes on one part of it, the entire system will become vulnerable to collapse.

  • If serious inflation continues, foreign governments will be unwilling to risk holding their reserves in US Treasuries. The Fed may need to raise interest rates to protect the US currency from depreciating.

  • Over the last few decades, the US has been able to cover its massive budget deficits by issuing debt. Continuous big budget deficits have been funded by selling US Treasuries to countries wanting to store their foreign currency reserves and to support trade denominated in US Dollars. As described in a previous post, countries are becoming less confident about the security of their US dollar assets, so increasing sales of US Treasuries are likely. The US budget deficit for 2022 is projected to be $US1.2 trillion, which will have to be borrowed. If this additional borrowing cannot be funded by foreign or US banks, the Fed may need to engage in further Quantitative Easing, which will feed into further inflation.

It is hard to know what central banks will do. Will they push up interest rates to restrain inflation, or will they let inflation go to protect their financial markets from pain? In the United States, you would presume that after a decade of quantitative easing, the capacity for further inflation of the money supply has been so exhausted. However, the willingness of politicians to inflate their currencies in order to maintain their political power should not be underestimated.

My guess is that politicians will go for the softer option and let inflation run, as they will be able to blame it on external players. They would have to take responsibility for any policy decisions that slowed the economy and politicians hate taking the blame. Of course, the outcome they don’t want to cause will probably happen anyway. So I expect to see inflation continuing to be a problem, with governments unwilling to take responsibility for taming it. This will be painful for people on fixed incomes and businesses that cannot deal with rapidly rising prices.