A balancing act is tough for central banks

The FED might announce the first rate hike at the March meeting.

This might seem like a standard switch from accommodative policy to something more restrictive but, in fact, it is not conventional at all and that means that the risks are high.

The central banks are hiking rates and others will join soon. It seems necessary, but when you listen to the likes of ECB President Lagarde, who says that tighter policy can’t easy supply chain tensions, cure Covid or lower oil prices, we might be tempted to ask, if that’s the case, then why bother? Central banks are clearly ‘bothering’ because, whatever caused rising prices, they are now left with inflation well above target and a risk that longerterm inflation expectations become unanchored. Hence, they have to respond.

Nonetheless, it does almost seem as if central banks are being a bit reticent in the hope that departing Covid and easing supply chains will bail them out so that they don’t have to hike rates to the extent that the economy crumples. But what if rising supply does not come to the rescue and the containment of inflation has to be done through demand suppression?

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said this is quite a worrying scenario in his view, particularly for the US. It is concerning because the huge – but temporary – recession in the first half of 2020 has counter-intuitively created a dramatic rise in household wealth. “We are more used to seeing recessions destroy wealth but factors such as the Covid-inspired surge in house prices and the dramatic bounce-back in equities have seen the wealth/GDP ratio rise by well over 20% since Q1 2020”, Mr. Steve Barrow said.

In short, the US has experienced significant goods and services inflation, as reflected in the CPI, and huge asset price inflation. In the past, we’ve tended to see one or the other, but not both, and that makes the Fed’s job hard. It is also hard for other central banks where household wealth has proved resilient for, while there’s lots of talk these days about consumers being pressurised by the rising cost of living (CPI inflation), the inflation in wealth provides something of a cushion. And that could mean that rising rates don’t cause the sort of demand contraction that central banks need should the burden of reducing CPI inflation fall on demand contraction because supply remains constrained.

The impact of Covid could continue to linger in an unhelpful way, not just because supply strains persist. Housing demand, for instance, could remain inflated by the desire for more space created out of the lockdowns. Higher wealth amongst the elderly could cause some persistence in what’s been called ‘the great resignation’, so keeping the jobs market tight and wage pressure elevated.

The story so far might suggest that central banks need to err to the hawkish side as supply might not recover and demand might not be as responsive to rate hikes because of this wealth cushion. But there is another side to the coin. For the very wealth that creates this cushion could actually prove to be the source of a very substantial decline in the economy should tighter Fed policy push assets like equities over a steep edge.

Mr. Steve Barrow said he has seen some suggestions that the Fed might actually need to create such a situation because only this will generate the necessary tightening in financial conditions that can rid the economy of inflation. He doesn’t really buy this point, but he believes that policy will have to be tightened by more than most anticipate. This is best done through lifting the fed funds target and normalising the balance sheet rather than presiding over a slump in equities but the danger, of course, is that the Fed might not be able to engineer the former without sparking the latter.

In short, the balancing act is very tough for the Fed and many other central banks and their chances of achieving success are quite limit ed, and that generally leaves us pretty negative towards G10 assets.