Markets on edge as central banks walk the inflation tightrope

Australia 10-year bond yields started the year at 1.67 per cent (having traded at less than half that when the pandemic first erupted in 2020) have climbed from 1.87 per cent to 2 per cent this month, their highest level since early 2019.

While that might not be good news for bond investors (bond prices fall as yields rise) it signals that central banks are finally getting what they once wished for – inflation – albeit that there is a risk that they might receive too much of a good thing.

It was the absence of inflation at sustainable pre-2008 rates and the low growth, productivity and business investment its absence signalled that created the historically aberrational pre-pandemic monetary settings.

Despite the unconventional settings, those policies had proved less than effective, with the floods of ultra-cheap liquidity pouring into financial assets – including negatively-yielding government and corporate bonds – rather than into productive investment or increased wages.

The same holds true, to an extent, for the even more expansive response of the central banks to the pandemic. They have poured near-costless liquidity into their systems.

The volume of money floating around in the US financial system, for instance, has swollen from less than $US16 trillion pre-pandemic to more than $US21 trillion today.

In most of the key economies, however, economic growth has picked up to levels not seen since 2008, despite the pandemic – or perhaps because of governments and central banks’ responses to it. There are even signs of wages growth.

Policymakers, and central bankers in particular, have an opportunity to shape the outcomes they have sought since 2008, where there is growth and low unemployment with moderate inflation.

Current inflation levels are unsustainable. When the US consumer price index is released on Thursday it is expected to show another increase, to about 7.3 per cent.

While the European Central Bank president, Christine Lagarde, has referred to “unanimous concern” within the bank over Europe’s 5.1 per cent inflation rate and investors are pricing in an end to bond purchases and a rate rise by mid-year, Lagarde has also said the chances of inflation stabilising at the ECB’s longstanding target of about two per cent (which is similar to the other major central banks) have increased.

The ECB is like the Fed and an even more cautious RBA. It believes the inflation rate will remain higher for longer than it previously thought but doesn’t believe it will remain at or above current levels for any great length of time and force a more draconian monetary policy response.

In some respects, that’s also the financial markets’ expectation.

Shorter term rates have spiked but a flattening yield curve signals that bond investors see inflation rates moderating in the medium term as the big driver of the surge in global inflation, the supply chain bottlenecks, gradually gets resolved.

There is a lot of money, however, parked on the sidelines. A lot of the cheap liquidity the Fed and its peers pumped into their financial systems wasn’t deployed in anything productive but has been deposited in financial institutions’ accounts at the central banks. There’s also vast amounts of government pandemic-inspired largesse sitting in household bank accounts.

If those funds were to be unfrozen and added a big surge in demand to the squeeze on supply the elevated inflation rates wouldn’t be transitory.

It’s impossible to tell at this point whether the pandemic and the central bank and government responses to it have enabled the major economies to sustainably break out of the low-growth, low-inflation malaise they’ve experienced since 2008.

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If unsustainable inflation rates persist the central banks will have to raise rates faster and further than they now contemplate, killing off growth – and probably sparking mayhem in financial markets – in the process.

Policymakers, and central bankers in particular, have an opportunity to shape the outcomes they have sought since 2008, where there is growth and low unemployment with moderate inflation.

The surge in market interest rates this month, however, suggests investors think they won’t move quickly enough and will have to tighten their monetary policies so aggressively they will not just kill inflation, but growth.

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