Inflation or recession? The unsolvable equation for central banks (EN/FR)
-----French Version Below-----
The global economy has been tremendously challenged in the past 13 months. Supply shortages after the COVID pandemic, the war in Ukraine and the decision of OPEC to reduce oil production, all led to rising inflation and economic slowdown.
The task central banks are facing is difficult; they must slow down inflation without tipping the global economy into a recession. The effect of a decade of virtually free money with low interest rates and massive asset purchases (Quantitative Easing) that started in the midst of the subprimes crisis in 2008 are now being felt across the board. This article aims at explaining the effects and consequences of this expansionary monetary policy on the current economic context and what it implies for economic agents.
I- The monetary policy since 2008
In 2008, Alan Greenspane, former Fed Chairman, declared during a hearing in congress that this crisis was a “once in a century credit tsunami”. Indeed, the bankruptcy of Lehman Brothers in 2008 which was, at the time, a well established institution, led to a loss of confidence in the markets. Banks started to be suspicious of one another and of the capacity of their counterparts to be solvent. However, the whole economic system relies on trust. If banks were to stop lending money (ie. financing the economy), this would start a domino effect that would lead other firms, unable to finance their activities, to file for bankruptcy. This phenomenon is known as “credit-crunch”. To avoid this situation, central banks started lowering interest rates, in other words, they made money cheaper. Hence, companies could borrow money at lower costs, invest and keep the economic system running.
For the first time at this scale, central banks introduced another monetary tool called Quantitative Easing (QE). This is a tool in which central banks buy large amounts of assets in the open market (mainly government bonds) to lower interest rates and provide liquidity to financial institutions. By providing liquidity, central banks incentivise financial institutions to lend money to companies and individuals in order to maintain production and consumption levels. Between 2007 and mid-2012, the size of the ECB’s balance sheet more than doubled. The ECB boldly increased quantitative easing with purchases of government bonds of countries where monetary policy transmission had been severely impaired. Increasing the Balance of the ECB raised a few concerns based on the high long-run correlation between inflation and money growth, for some it was a sign for future high inflation. But for ten years the inflation rates have been well below 2% (the ECB’s target).
The graph below shows the total assets of central banks as a percentage of GDP. It illustrates the importance of asset purchasing of central banks and its magnitude with regard to the size of the economy.
The problem is that quantitative easing had never been used for such an extended period of time and at such a scale. There are therefore many uncertainties with regards to the consequences of stopping QE. Central banks realized that markets and economics agents became used to working with high levels of liquidity and governments relied on this policy to lower their borrowing costs. Now that central banks need to regain control over inflation, the question of the long term effect of quantitative easing is more relevant than ever.
II - What have central banks been doing so far?
The measures to fight inflation are both straightforward and complex. Complex because, in times of great volatility, as it is today, economies can face a series of shocks which produce rising and persistent inflation. In the 1920s, inflation was driven, in part, by ever lower exchange rates and severe supply bottlenecks, including for energy.
Straightforward, because there is only one way to counteract these effects, reduce the Balance of the ECB and the rise of interest rate to cooldown the economy and return to an acceptable inflation rate.
By the end of October 2021 the inflation rate in Europe was around 4.4% more than twice the target of the ECB and climbed to reach 9.6% in June 2022!
In the US the inflation rate had reached 6.2% in October 2021 and 8.5% in March 2022.
The central banks had to react, both the ECB and the FED reaffirmed early on their commitment to their mandate “Price stability, with inflation rate of 2 percent”, this strong stance has led the markets to price in this information even before the actual rate increase.
For the first time since March 2016 the ECB raised its interest rate from 0% to 0,50% in July 2022. This decision was followed in August to an increase to 1,25% and in October to an interest rate at 2%.
The FED tackled the problem 3 months sooner than the ECB and successively raised the interest rate to 0.33% in March, 0.83% in May, 1.58% in July, 2.33% in August, 3.08% in October and most recently to 3.83% in November.
III- Why is it so difficult?
The question central banks must answer could be stated as follows : “How to slow down inflation without tipping the economy into a recession”. This is difficult because by definition anti-inflationary measures have a negative impact on growth and output. Indeed, raising interest rates slows down the economy by making investments and consumption more expensive.
To understand how this problem can be addressed, it is important to focus on what drives inflation. As mentioned in the introduction, supply shortage has a large impact on inflation. During the pandemic, there were many disruptions in the supply chain which made it difficult for companies to maintain their production levels. This was not an issue during the successive lockdowns as consumption also dove. However, consumers had savings from foregone purchases during the pandemic. When the restriction started being lifted the demand surged with a supply unable to catch-up. This gap between supply and demand naturally led to a sharp increase in prices.
Central banks are aiming to increase interest rates enough for the demand to slow down and allow the supply to catch up. Taming inflation while maintaining growth and unemployment steady is called a “soft-landing”.
But the ability of central banks to achieve such an outcome is highly dependent on exogenous factors such as the evolution of the war in Ukraine and the jump in commodities and energy prices.
In the last quarter the world’s three largest economies (China, the US and the Euro zone) have been flashing warnings of recession. Central banks now have to walk a thin line between tipping over the economy in a worldwide recession or successfully answering the inflation issue.