Central bankers, the shining saviors of the global economy after the global financial crisis and again during the COVID-19 pandemic, are fast becoming the villains of the prevailing narrative. Noodling with interest-rate hikes that are too late and too small, and trimming morsels off their swollen balance sheets will not prevent inflation from soaring toward double digits.
However, crashing into recession to compensate for being asleep at the stimulus wheel for too long would just be a different flavor of failure.
What is needed is for fiscal policy to shoulder more of the economic burden.
After a brief period of joined-up thinking, when increased government spending was coordinated with innovative stimulus programs, we are back to central banks as the sole bulwarks against stagflation. The current disconnect between fiscal and monetary policy leaves the guardians of financial stability — and their independence — dangerously exposed to attack.
Walking the tightrope between curbing roaring inflation and plunging the economy into recession poses a dilemma for the European Central Bank. As the hawks on its governing council clamor for an imminent end to quantitative easing and a swift end to negative interest rates, removing stimulus too quickly could easily result in a sharp slowdown next year for the always precarious eurozone economy.
The saving grace is that, so far at least, there is little evidence of spiraling wage rises. That is exactly where the bloc’s governments can help, by alleviating the impact of surging energy prices on consumers to mitigate second-round inflationary effects.
The EU scored a big win in creating the 800 billion euro (US$840 billion) Next Generation fund last year to offset the economic hardships of the pandemic, but its collective fiscal response to Russia’s invasion of Ukraine has been lackluster.
The EU’s great strength is its flexibility under adversity. It should match the coordination of its military and sanctions reaction with a package to sustain growth while smoothing the price repercussions of the war.
The Bank of England’s task is even harder given the tax increases introduced by British Chancellor of the Exchequer Rishi Sunak. It is not a great look for a central bank to hike interest rates at its fourth consecutive meeting while suddenly warning of impending recession risks. Jacking up borrowing costs can only make the cost-of-living crisis worse, hence the growing splits on the Bank of England’s Monetary Policy Committee between members prioritizing the need to calm inflation with those worried about the British government’s fiscal squeeze.
London seems deaf to the pleas of finance experts to mitigate the coming drop in living standards.
With the Bank of England perceived to be losing its appetite for tackling rising consumer prices and forecasting stagflation, traders and investors are understandably increasingly wary of sterling assets.
Meanwhile, the US Federal Reserve sees no obstacles and is accelerating its tightening. That is widening the interest-rate differential to other currencies, further propelling dollar strength and causing havoc in the foreign-exchange market, to the particular detriment of emerging-market economies.
However, the Fed has little choice in mopping up after too much stimulus from the US government. The prospect of political gridlock after November’s mid-term elections in the US does not bode well for the already faltering administration of US President Joe Biden. At least with the previous Fed chair now heading the US Department of the Treasury, there should be some hope for synchronization between the fiscal and monetary response to the economic challenges ahead.
Deflating the economy to cool super-hot labor markets and trigger demand destruction is the goal that the Fed and the Bank of England are pursuing. That not only risks wasting the trillions spent on pandemic recovery efforts, it also might not be controllable. The cure could be worse than the illness, shredding already wavering confidence in the ability of monetary authorities to fulfill their mandates.
Nobody wants to go back to politicians deciding interest rates. So there has to be a realization of the limits of what monetary action alone can achieve when the world has been effectively shut down then turned back on again amid global supply chain disruptions and a war-induced energy crisis. Central bankers have little to no control over the supply side, and can only clamp down on the demand that they were so recently stoking with fervor. Governments can tinker with the production side, but only where it makes commercial sense. It takes a long while for infrastructure or other grand projects to generate any meaningful economic effect, but there is much more fiscal policy could be doing, particularly with taxes and investment incentives.
Stocks and bonds are already flashing red about the economic dangers ahead. Fiscal and monetary policies can and should be coordinated without undermining the independence of either set of policymakers. It is time for global authorities to repeat the creativity they displayed during the pandemic.
They should act now, in haste.
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was lead markets strategist for Haitong Securities in London.
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