Growing central bank desperation

Dr Bryce Wilkinson
NZ Herald
23 June, 2022

On Monday this week, the prime minister said she was optimistic that the economy would not shrink further in the second quarter. That would avoid New Zealand officially being in recession.

Well, it is good to be hopeful. However, whether economic activity in the June quarter is slightly higher or lower than in the March quarter is irrelevant in the grand scheme of things.

International financial instability is a much bigger threat to incomes and jobs in New Zealand. New Zealand is a trading nation, and central banks and governments around the world have created the worst financial mess seen during peacetime.

The chances of a major recession in the world economy are rising, but you might not know that from the largely internally-focused Treasury or Reserve Bank assessments.

Debt ratios in many countries are at levels that have not been seen since the end of World War II. Central banks have created too much credit and artificially lowered interest rates. Despite the Covid-19 shutdowns, world share markets reached record high levels.

But that "game" has now run its course. The days of reckoning are here.

With inflation on the rise, central banks are now in a bind. To maintain credibility, they must raise interest rates. Yet, by doing so, they will look like villains. They will make their governments' fiscal positions worse. Shareholders and bondholders will lose a lot of money. They will know who to blame. Borrowers who invested in risky assets will go bankrupt.

Can central banks get inflation down to 2 per cent pa without causing a major recession? According to the IMF and the OECD, they can. Their optimism might reflect fear of being blamed if they forecast a severe downturn which then happened.

Charles Goodhart, a world-renowned former Bank of England economist, wryly commented earlier this year that it would be easier to land a Boeing 747 on an aircraft carrier in a storm than for central banks to control inflation now without a recession. Those are poor odds.

Investors are losing confidence in the European Central Bank. It held an extraordinary meeting last week to "discuss market conditions". The issue turned out to be "fragmentation". "Fragmentation" appears to be a euphemism for divisions that could, if unchecked, break-up the Euro.

After that meeting, a spokeswoman announced that the bank's commitment to anti-defragmentation "has no limits". Really, does taxpayer support have no limits?

We have seen this desperation before. The bank committed in 2012 to do "whatever it takes" to save the Euro. Before the onset of the last global financial crisis, the bank's total assets were 1.3 trillion Euros. After that crisis, they peaked at 3.1 trillion. That rise was unprecedented in the bank's decade-long history.

And still, by today's standards, even that is minor. The bank has since been propping up European central governments by buying their debt at very high prices. It is particularly soaking up Italian government debt.

The bank's total assets are now a monumental 8.8 trillion Euros and, surprise, surprise, inflation is now a problem. Can there really be "no limit" to this collective folly?

What is happening is that investors in Italian government bonds increasingly doubt that the bank can hold the Euro countries together. That doubt has seen the margin between the (low) yield on German government bonds and the higher yields on Italian government bonds increase to a degree that has alarmed the bank.

This would not have happened if investors were confident that the Euro system would not break up and the Italian government would not default.

Investors are being rational. When the Euro system was set up, its member governments agreed to keep their gross public debt below 60 per cent of gross domestic product (GDP). Italy's government debt was 160 per cent of GDP in 2021, according to the OECD. At 201 per cent of GDP, only Greece was higher in Europe.

In addition, euro countries agreed to keep deficit spending under 3 per cent of GDP. Over the last 20 years, Italy's deficit spending has averaged 3.5 per cent of GDP. For 2022, the OECD's forecast is 6.1 per cent of GDP.

Investors doubt that the bank can keep buying Italy's government bonds to bail it out. To do so feeds the problem. Why should Italy or others be prudent if Italy is allowed to be imprudent and has unconditional bank support for that?

The bank and investors know the numbers are huge. Italy's general government debt is over 2.5 trillion Euros.

When Italy is both too big to fail and too big to save, there is a problem.

Another big one to watch is the US. The Federal Reserve knows that its credibility is at risk. It has just lifted its central interest rate into the 1.5-1.75 per cent range.

The rate of inflation in the US is still far higher. The Fed intends to lift its interest rate to 3.75 per cent peak next year. It expects to reduce it to below 3.5 per cent in 2024.

To reach 2 per cent inflation a year surely needs higher interest rates. US economists look to a 'Taylor' rule to gauge where they might need to be. The Federal Reserve Bank of Atlanta even provides an online calculator for this purpose. Currently, it calculates that the Fed's interest rate needs to be between 5.6 per cent and 7.1 per cent.

The current mess partly results from an excess of hubris among central banks. They believed they had enough low-inflation credibility to be able to flood world financial markets with liquidity without generating inflation. They thought Inflation expectations were so stable they could undo the stimulus before it was too late. They talked of a temporary rise in prices.

Premature claims of pressing financial system risks from climate change have also been a self-promoting distraction.

Events have shown that the pressing risk is from central banks and their indebted governments. We need less hubris from central banks and a much greater focus on excelling at their core task – preserving the value of money.

In the end, we – as consumers, investors, entrepreneurs and citizens – pay the price for this collective failure by the world's central banking elite.

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