Money Dealer Driven Global Monetary Tightening Ahead – A Catastrophic Drive for the Global Recovery from the Coronavirus?

 

Last article posted on October 30 provided my views on the inappropriateness of the Mainstream Economics for the recovery and rehabilitation of economies from the Coronavirus and the urgent need for a New-stream Economics. In this context, this article presents my views on the inappropriateness of the present market-based monetary policy models and the need for a new model as part of the New-stream Economics to serve the general public.

In less than 2 years of the historic monetary policy relaxation to fight the global Coronavirus, money market/investment analysts have started predicting the tightening phase of the monetary policy cycle soon on account of rising inflationary pressures and resulting increase in market interest rates. This is in line with the monetarists’ version of the monetary policy to control the inflation or inflation targeting monetary policy to sustain the price stability in the economy. 

This is based on a blind concept of the disequilibrium of the economy resulted from the mismatch between aggregate demand and aggregate supply that causes inflationary or deflationary outcome of the economy. Therefore, rising inflation beyond targeted or acceptable levels is believed as a result of the aggregate demand being higher than aggregate supply. This leads to a simple policy prescription of tightening the monetary policy to control the money supply/stock in the economy as the money stock circulating in the economy is considered as the key driver of the aggregate demand and disequilibrium.

Monetarist Hypothesis on Inflation and Money Dealers’ Behaviour

The monetarists believe that the money supply rising faster than the growth of production or real GDP causes inflation through aggregate demand higher than the real GDP (aggregate supply). Therefore, when the growth of money supply rises continuously, markets or investors expect rising inflation and, as a result, push market interest rates upwards with a premium for inflation risk in order to protect the value of money or investments in terms of real interest rates (interest rate adjusted for expected inflation). 

Accordingly, profit frenzied money dealers gamble in the market between inflation and interest rates by speculating the monetary policy to follow suit by tightening sooner or later. They even suggest or predict a time bound course of monetary policy tightening and take investment positions and portfolio readjustments in that line. This becomes more active and dynamic closer to monetary policy meeting dates.

Monetary Policy Response to Money Markets

After some time, central banks find it extremely difficult to maintain the present monetary policy stance (policy interest rates and asset purchases/money printing) and happen to lean with the market trend in order to prevent the monetary policy getting out of the market. As the hawkish monetarists also support the views of money markets and dealers by habitually raising concerns over rising inflation, central banks run out of policy options other than the reverse gear of starting to tighten the monetary policy. As the tightening phase of the policy cycle also is to take few years, central banks have the opportunity for mid-cycle adjustments if the response of the economy is turned out to be unfavourable.

Central banks will twist their technical jargon used in policy communications to justify whatever policy actions they consider fit for the time being. The fine recent example is the US Fed’s policy tightening in 2017-18 after a decade of ultra-loose policy followed to fight the global financial crisis 2007/09 and the reverse gear taken in 2019. The Fed Chairman recently commented that same policy mistake would not be repeated at this time.

Present Global Inflationary Pressures and Money Market Response

Despite ultra-loose monetary and fiscal policies pursued since the beginning of 2020 to fight the global recession and instability caused by the Coronavirus, new variants of the virus and grave uncertainties prevailing across the globe have prevented the recovery of the global supply chains disrupted by the Coronavirus, Therefore, supply side bottlenecks continue to hamper the recovery of growth and employment and have caused significant price increases and pressures in many markets led by labour market and energy market whereas supply crunches have become a widespread phenomenon.

As a result, global surge in inflationary pressures is seen building up during the past three months where it is especially concerned in developed world due to such a level of surge reported first time in the last two decades. Although central banks initially considered such inflationary pressures as transitory which would disappear when the supply side disruptions are eased gradually with the control over the Coronavirus spread, now they tend to believe that these inflationary pressures are seen to be longer than initially expected, especially due to the global energy crunch and significant price hikes. However, inflation figures based on consumer price indices have increased so far only up to 3%-4% over the 2% target (average over time - medium or long term) in the US, UK and Europe in the past few months whereas the surge in inflation in developing countries who normally confront higher rates of actual inflation due to structural problems is not seen significant.

This is the environment in which actual inflation as well as inflation expectations are believed to be rising and market interest rates are adjusting upward in that line where hawkish monetarists have become active and aggressive by recommending the urgent need for monetary policy tightening to tackle such inflationary pressures now at its first round itself before it gets spread to subsequent rounds and become permanent. As a result, a global monetary tightening virus has emerged among central banks on the top of the Coronavirus uncertainties. This will become a global waive no sooner the leading central banks join the tightening drive as already seen from some policy signals in line with market analysts.

Policy Tightening Signals by Leading Central Banks in the Past Week

Present monetary policy of these central banks contains two major elements, i.e., interest rates (policy interest rates and overnight inter-bank interest rates/short end of the yield curve) close to zero and printing of money through asset purchase (Quantitative Easing). Since the last month, these central banks have been expressing views that the next policy direction would be to commence tapering asset purchases first and then to start raising policy interest rates when the economy is tested to have been fully recovered from the Coronavirus. Accordingly, market analysts have been predicting timetables to start tapering quite soon and interest rate hikes from mid-2022 onwards. Now, central banks are seen tending to fall in these time targets and commence tapering first as cited below.

• European Central Bank (ECB) - Policy meeting held on 28 October 2021

The ECB decided that “favourable financing conditions can be maintained with a moderately lower pace of net asset purchases under the pandemic emergency purchase programme (PEPP) than in the second and third quarters of this year, within the total envelope of €1,850 billion until at least the end of March 2022.” However, the asset purchase programme existing from 2007/09 global financial crisis policy stance will continue at a monthly pace of €20 billion of net asset purchase. Accordingly, all other policy instruments, i.e., policy rates and long-term refinance schemes, would continue at current levels. Therefore, it appears that the ECB is now inclined to the market view of tapering.

• Australian Central Bank (RBA) - Policy meeting held on 02 November 2021

The RBA decided to scrap the policy of the yield curve control at the target yield of 0.10% (same level of the overnight cash rate or policy rate) for the April 2024 Australian Government bond. In fact, this happened on 28 October as the RBA did not purchase the April 2024 Australian Government bond in the secondary market and, as a result, the yield skyrocketed to 0.80% immediately.

Further, at the Policy meeting held on 03 August 2021, the RBA decided to reduce/taper the asset purchase from the rate of $5 billion a week to $4 billion a week from mid-September until at least mid-November.

However, policy interest rate and term financing facility will continue. Therefore, it appears that the RBA is now inclined to the market view of tapering.

Australian inflation has not yet exceeded the target of 2%-3%. Therefore, RBA states that the present scenario does not suggest any policy rate hike in 2022 and, if inflation and wages are to rise, a rate hike could be warranted in 2023. Therefore, RBA appears to have inclined to the market view of the rates hikes too.

• US Central Bank (Fed) - Policy meeting held on 03 November 2021

The Fed decided to reduce or lower the monthly net asset purchases by US$ 10 bn for Treasury Securities and by US$ 5 bn for Agency Mortgaged Backed Securities from the end of this month (November). Accordingly, monthly holdings will increase by US$ 75 bn for Treasury Securities and US$ 35 bn for Agency Mortgaged Backed Securities for this month. Further, same size reduction will be effected in December too, i.e., monthly holding will increase by US$ 70 bn for Treasury Securities and US$ 30 bn for Agency Mortgaged Backed Securities.

The Fed also decided that, if the economy evolves broadly as expected, similar reductions in the pace of net asset purchases will likely be appropriate each month so that increases in Fed’s securities holdings would cease by the middle of next year.

However, the Fed communicated that it is prepared to adjust the pace of asset purchases if warranted by changes in the economic outlook, and even after its balance sheet stops expanding, its holdings of securities will continue to support accommodative financial conditions.

Therefore, this is only a start of tapering of the current monthly phase of asset purchases and, not a tapering of the existing stock of asset holdings, and it can reverse at any time if the US economic recovery confronts new uncertainties.

At the press conference, answering to a question on when to commence lifting interest rates, the Fed Chairman responded that it was not a question before the Fed as yet and, the question it had was on when to taper and was answered. He further clarified that the lifting interest rates would be dependent on the test of the economy reaching maximum employment consistent with the price stability at long-term average inflation target of 2%. This shows that the Fed also has been influenced by market force on tapering.

• UK Central Bank (Bank of England - BOE) - Policy meeting held on 04 November 2021

The BOE decided to maintain the current policy stance, i.e., Bank Rate at 0.10% and the target of total stock of asset purchases at £895 billion, to support the economy recovering from the Coronavirus and supply chain disruptions, despite the rising inflation, i.e., 3.1% between September last year and September this year.

However, the BOE expects inflation to rise further to around 5% in the spring next year and, therefore, interest rates will need to rise modestly to return inflation to its 2% target. Therefore, the BOE is not seen inclined to tapering view, but seen to lean with the market view for raising interest rates to tame the rising inflation. This is the first time in the current monetary policy cycle that the BOE signals the need for raising interest rates over inflation concerns. The BOE Governor commented at a media interview that the market pricing was in the right direction, but a bit overdone, and it would act if medium-term inflation expectations were seen. 

Therefore, money market dealers who had built up positions on the speculation of a rate hike by the BOE in November were frustrated with losses by this monetary policy decision. The BOE was blamed by money dealers for misleading the market by pre-signals of a rate hike in view of inflationary concerns.

• Recent Policy Move by Few Other Central Banks

Several central banks of emerging market economies also have started policy tightening in view of rising inflationary pressures due to same causes, i.e., supply bottlenecks and energy price hikes and money market pressures. However, these central banks have chosen the tightening through hikes in policy rates while asset purchases/money printing continue without any announced targets. The Bank of Korea, Central Bank of Sri Lanka, Central Bank of Norway, Central Bank of Brazil and Central Bank of Poland have already raised the policy rates (by a range of 0.25% and 1.50% and Central Bank of Sri Lanka with further 2% increase in SRR) to follow the money market pressures. As a result, money market rates and government securities yield rates/yield curve have further risen, which would cause a financial/credit crunch in addition to prevailing supply side crunches and bottlenecks in these countries.

However, Central Bank of China seems to be further relaxing the monetary policy by injecting term liquidity to address supply chain crunches while another cut in SRR is expected. Meantime, Central Bank of Turkey cut the policy rates two times in total of 3% during the last two months (with the direct intervention of the President), despite the market pressures for higher interest rates to attract foreign capital, heavy depreciation of the currency and rising inflation. The cut in interest rates is intended to reduce the cost of credit which would reduce the level of cost-push inflation.

General Comment on Monetary Policy Tightening Hypothesis and Its Real World Consequences

In general, central banks across the world will follow the policy direction of the US Fed as the US dollar is the leading reserve currency. This will really happen when the Fed starts to lift its policy rate (Federal Funds Rate Target which is 0-0.25% at present) which will cause significant volatility of capital flows as capital from emerging market economies will tend to flow to the US seeking secured high returns. The most recent experience is the US policy rate hike during 2017-18. Further, the resulting surge in interest cost and liquidity/credit crunch will aggravate the present supply side bottlenecks where the resulting increase in cost of credit will be passed on to prices and wages in the near-term pushing up further inflationary pressures driven by cost-push factors added by high interest rates.

Therefore, it is highly likely that monetary policy tightening, if continued, will drag the global economy further into recession and supply side disruptions in coming years, perhaps with financial system instabilities. Although the present level of envisaged tapering is trivial as compared to the total increase in global money printing of nearly US$ 9 trillion so far under Coronavirus induced monetary policy relaxation, the messaging around will cause immense uncertainties harmful to the global recovery from the Coronavirus. Therefore, the present inflation-pulled monetary tightening will not be practical or feasible in view of the prevailing supply side bottlenecks and uncertainties caused by the unknown Coronavirus that has caused an extraordinary time and difficulties for the global economy and people. 

Further, such tightening would cause policy contradictions with the governments mainly due to hike in cost of and liquidity problems in budgetary financing required for fiscal stimulus to support the recovery and rehabilitation of the economies out of Coronavirus. Therefore, current global economic developments do not fall within the normal macroeconomic concept of aggregate demand management to match the aggregate supply movements as recommended in Mainstream Economics.

The policy governance also seems to be questionable.  First, concerns over leakage of market sensitive information from central banks through various means to money dealers engaged in insider dealing practices are widespread and risks to credibility of central bank policies are high. The Bank of England recently withheld meetings with banks held to seek market information useful to the policymaking as such meetings invariably helped banks other way around, i.e., banks to figure out information on near-term policy moves that help banks to make profit.

Second, recent revelation of conflict of interest created through active investments by senior central bank officials in securities involved in asset purchases and OMO by central banks for monetary policy also is a blow to policy credibility of central banks. Therefore, the Fed recently imposed ethical restrictions and compliance reporting applicable to financial market investments made by the senior Fed officials.

Therefore, the commencement of the present monetary policy tightening stance is likely to be highly risky to the global economy due to its conceptual invalidity at present time in view of the global Coronavirus conditions. Therefore, the recovery and rehabilitation of economies from the Coronavirus require a new design/model of the monetary policy that can support the fast and sustainable recovery of supply chains and supply side in association with the fiscal stimulus largely free from speculative attacks of profit frenzied money dealers and money market traps.

Unlike in the case of price controls in commodity markets, central banks have the liver in money printing without pre-determined limits to guide and control financing conditions as appropriate for the economy and general public in modern monetary/credit societies with state money. Therefore, central banks seeking to lean with the money markets regardless of the real requirements of the economy are questionable. Further, central banks and monetarists do not have a practical framework other than hypotheses to separate the impact of money/credit between the general price movement/inflation and the real performance of the economy. In other words, the separation of the impact of the growth of money/credit between the consumer expenditure causing inflation and the investment expenditure promoting the growth of real GDP and employment is not available. What is generally understood is the inclusiveness of money and credit in the economy and living standards of the general public.

Therefore, it is highly unacceptable that monetary policies are inclined to movements of speculative money dealers and hypotheses of mainstream monetarists as such monetary policies themselves could be the source of many instabilities in the economies and living standards. What if hypothetical inflation targets adopted at present to run the monetary policies are doubled in view of current extraordinary circumstances connected with the unknown Coronavirus and continue with the present relaxed policy stance until the Coronavirus connected uncertainties are subdued?

At the end, present model of inflation targeting is only an arithmetic exercise over the average rate of growth of the consumer price index whereas the monetary policy should be an extensive macroeconomic management exercise over money and credit to support the economy and living standards.

(Next article will focus on features of the new model of the monetary policy suggested by the author)

P. Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka