You’re not going to believe this, but the busy bees at the European Central Bank (ECB) might actually do something to rein in inflation. And, at double digits in many economies, it’s not a moment too soon.
The new form of monetary policy came out of the blue and I’m still amazed at its ingenuity. It’s the first form of what central bankers call “unconventional monetary policy” which might actually work.
What is it? I’ll let the Financial Times headline tell you: “ECB staff in pay dispute to hold talks about potential strike.”
That’s right, the money printers might put down their tools and stop the presses!
There’s nothing like a central bank without staff to slow down inflation
You might laugh at my attempt at a joke… or perhaps not… but consider this bit of the FT story: “A strike, as happened at the ECB over pension reforms in 2009…” Yep, that’s precisely when inflation tumbled and even went negative in the euro area…
Coincidence? I think not!
Snarky comments aside, the possible ECB strike really is about inflation. The workers are upset by the lack of wage increases relative to the inflation they caused.
That makes sense to me. After all, if you’re not going to get a pay rise to compensate you for inflation, why show up to work and create it?
They probably should’ve figured this out beforehand though. Of all the people to remember to index their incomes to inflation, the money creators forgot to…
OK, enough humour. The real challenge is that the bosses at the ECB can’t give in to their workers’ demands. Not without undermining their own demands that nobody else in the economy hike wages to keep up with inflation for fear of triggering a wage-price spiral.
This fear is surprisingly real. In the book When Money Dies, Adam Fergusson carefully explains that public sector pay was a key issue when it comes to slowing inflation after the Weimar debacle.
This makes sense because it’s those public sector workers who get the newly created money first when central banks monetise government debt, so they’re at the front of the inflationary pressure wave.
They also have an impact on wage rates right through the rest of the economy by setting prices for labour which are not market determined like other wages. If people can choose between government and private sector jobs, but government sets high wages, then the private sector has to raise wages to keep up.
Alternatively, we could all work for the ECB and create money at higher wages, but Frankfurt is – for many people – a dreary place.
Meanwhile, across the pond…
While the ECB is in a real pickle of its own making, the American version of the same phenomenon is, well, typically American.
Think about it. How would Americans get central bankers to tighten monetary policy and cut inflation?
The answer is simple. Expose that they’ve been busily speculating with their own private stock market accounts while also making the monetary policy which inflated stocks in the first place.
Once central bank policymakers’ speculation in the stock market was exposed in the media and banned, the central bank yanked the reins on inflation and the US markets have crashed as a result…
Coincidence? I think not!
But the conventional monetary policy pursued by the US Federal Reserve only works with a lag, unlike the ECB version of simply shutting up shop. And, now that I really have finished with the snarky comments, I want to explore something really important to investors in coming months.
Room to fall
It’s a simple enough question. What matters more – the level of interest rates, or their magnitude and direction of change?
On the one hand, central banks’ interest rates remain highly stimulatory. Around the world, inflation is running at about double the central banks’ interest rate, after all. That means borrowers can borrow money, buy widgets and profit handsomely from mere inflation alone.
This should be rather good for the economy. At least, it should benefit the parts of it that are impacted by debt-financed spending.
Of course, that’s not how it works in reality. Especially with house prices plunging. But does it even work that way theoretically speaking?
Ever since inflation stopped being “transitory”, central bankers have been hiking interest rates like mad. The consequences make for a lot of dramatic news headlines.
US investments had their worst year ever, once you adjust for inflation. Housing bubbles around the world have popped (yes, even in Australia). And much of the world economy is going into recession.
It sounds to me like the theory of low interest rates doesn’t describe the situation so well. It sounds like the direction and speed of travel of interest rates matters more than their level relative to inflation.
Why does that abstract idea matter?
Well, central banks around the world, with the notable exception of Japan, have embarked on an epic rate-hiking cycle. They’re hiking far and fast. This is despite extraordinarily large debt burdens in their respective economies.
They are trying to tighten monetary policy to rein in inflation. But, as I’ve just pointed out, it’s not entirely clear what “tight” monetary policy actually is.
On the one hand, interest rates are still very low. That is low both historically speaking and – especially – given the rate of inflation. This implies that plenty more rate hikes are needed to get inflation under control.
Alternatively, the speed and extent of the rate hikes is blistering. The rises are so fast that they risk breaking something… or someone. It’s a bit like what happened in the United States in 2003-2006, when a comparatively moderate rate hiking cycle triggered a… memorable experience for investors.
So, which is more important? The level of rates or the hiking itself?
Another theory claims that that’s the wrong question to ask in the first place. It argues that there is a hypothetical and unknowable level of interest rates that is “neutral” – neither stimulatory nor hawkish for the economy. What really matters is whether the interest rate set by central banks is above or below this unknowable number.
Keep interest rates below this figure and you get inflation and/or housing bubbles. Keep it too high and you get a recession.
Under this school of thought, you can’t tell whether monetary policy is loose or tight based on the interest rate alone, nor its direction of travel. You can’t tell, full stop. That is because knowing what the neutral rate might be is impossible.
Therefore, the price of money (the interest rate) should be left to the free market. The same one that determines far more important prices, such as food, every day.
Why don’t we have a central food bank setting food prices? That is because we wouldn’t trust them to get it right. And yet, we trust central bankers to set the interest rates just right. Well, we believe we need them to do it, anyway.
So, let’s not kid ourselves. No matter how clueless central bankers are proven to be, they won’t give up on meddling with interest rates.
If it’s the rate of change in interest rates that really matters, this also explains why prolonged periods of zero interest rates since the global financial crisis didn’t provide any stimulus in much of the euro area economy.
And it suggests that monetary policy requires room to cut in order to function during a downturn. You have to be able to lower interest rates to fight off a recession, not just have low rates.
That’s because every mug who’s willing to borrow at 0% interest rates has already fallen for it. To get an additional borrower sucked in, you need to go even lower.
Central banks in different places
With much of the developed world facing a recession, and the corresponding interest rate cuts that go along with it, this creates some important conclusions about future investment trends.
The US’ Federal Reserve, thanks to a rate hiking cycle that was so fast that it blew up its bond and stock markets in the first half of 2022, has room to cut rates. It can lower them quite substantially to fight off a recession.
The UK and Australia were laggards when it comes to rate movements, but there’s still room to lower rates.
The euro area? They’ve barely started hiking rates. And so, with European economies going into recession, they won’t be able to cut them as much either.
This implies the Europeans will struggle more with their coming recession.
As for the Japanese, they’ve given up on inflation to focus on funding their government at 0% rates and keeping the yen off the floor as a result. This is, quite frankly, an insane monetary experiment which punts on persistent deflation rescuing the situation. That is deeply ironic given how much central bankers fear deflation…
Anyway, each economy is peering into the recessionary abyss from a different level of interest rates. And should fare differently as a result.
Of course, the timing is not quite the same. The United States had two consecutive quarters of shrinking GDP in 2022 – the definition of a recession for everyone except the American economy.
And it’s important to keep in mind that monetary policy works with a lag. A lag that isn’t the same across economies.
The United States’ mortgages are largely fixed rate, so the higher rates apply less to indebted households and more to borrowing capacity and corporate borrowers.
In the UK and Australia, variable rates dominate, but only after fixed periods. We’re seeing the first pandemic borrowers hit interest rate reality now. There is plenty more of that to come!
In Europe, the mortgage Terms & Conditions vary wildly. As do the sovereign debt levels… and inflation rates…
Imagine having to set one interest rate for economies that have completely different debt levels, inflation rates and mortgage rate setups…
It’d be a nightmare. Actually, it will be a nightmare. Because if half the euro area goes into economic meltdown, and the other half continues to have inflation, what the hell is the ECB going to do?
Nick Hubble
Editor, Fortune & Freedom
