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Home Finance A central bank’s balancing act

A central bank’s balancing act

by jcp
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by Nicky Maan, CEO of Spectrum Markets

During times of rapidly rising prices, calls from politicians and markets for interest rate hikes are not long in coming. In view of the price stability mandate of the European Central Bank (ECB), public claims for Quantitative Tightening, a shortage of the money supply in the form of interest rate hikes and similar measures are more than understandable.

A far less recognised, yet no less important objective of a central bank during inflation is to manage people’s expectations about future price developments. The aim here is to avoid a phenomenon known in technical terms as De-anchoring. In the context of inflation expectations central banks consider these as ‘anchored’ where people expect long-term price increases to remain relatively unchanged even if prices temporarily rise beyond their short-term inflation expectations. Accordingly, expectations are de-anchored when people’s long-term inflation expectations go up considerably as a result of prices rising beyond their short-term expectations only temporarily. This may explain why central banks didn’t react to high inflation rates over a longer period until they finally started rate hikes in summer. Now for them it is important that they keep the credibility of their open market operations to show an impact. If they fail by under-tightening, the cost of fighting inflation will become even higher – an effect better known as wage-price-spiral.

Overdoing the quantitative tightening would, however, be equally detrimental to the credibility of the ECB as it would incur significant economic burden. Hence, it has to find the right balance avoiding both a too weak stance on inflation and a too aggressive increase in the cost of money. This is even more sensitive due to the fact that European economies are each exposed to factors putting pressure on prices in a different manner. Italy, for example, whose economy developed better than those of the other major European countries at the beginning of the year, was greatly dependent on Russian gas, the same being true for Germany. Energy supply shortages threaten to weigh on industrial output. France and Spain, for example, are better off in terms of energy independence. France has a strong nuclear power sector which it kept despite the security discussions around this energy source. Spain has been importing shipped liquid gas making it less vulnerable to supply shortages. Its consumer price inflation was at 5.7% year-on-year in December – I think this is very illustrative of the dominant impact of the costs of energy.

Then there are different structural issues across countries within and outside the European Union, such as in the United Kingdom which faces challenges resulting from Brexit. And the same heterogeneity in terms of exposure to the effects of rate hikes is applicable worldwide with a demarcation line between developed and emerging markets. So, from a monetary policy point of view, I would deem the current situation even more challenging than at the peak of the Covid-19-pandemic.

For the ECB, this is particularly challenging. It faces the additional challenge that the national governments of Eurozone member states are still strongly divided about how their fiscal policies could be aligned. Remember the Stability Growth Pact (SGP) which has been a bone of contention since the very beginning? The SGP was suspended in the aftermath of the pandemic and the suspension has been extended until the end of 2023 as a result of the Russian invasion of Ukraine. According to the SGP, a country’s budget deficit should be capped at 3% of its economic output while government debt shall remain below 60% of the country’s gross domestic product (GDP). However, the rules weren’t followed consistently even before the global financial crisis fourteen years ago and it got worse thereafter. The debt to GDP ratio of Greece, despite the progress the country made, is still at around 190%. Italy, with outstanding credit of some €1.8bn, is indebted by over 150% of its GDP. Estonia’s debt to GDP ratio is below 20%. The ECB’s monetary policy steps have to account for multiple different effects one open market operation will have due to an economically and, more importantly, politically fragmented environment. While being somewhat distant to what Great Britain has experienced in terms of doubts regarding its debt servicing capacity, the Eurozone’s clumsy manoeuvrability in structural aspects hampers its capacity to fine tune and align relevant fiscal and monetary policy measures.

What’s more, it’s not exactly an easy exercise to tell when in a recession. First, you need to decide what you would define as recession. Everybody will understand it is when the economy goes down, jobs get lost, corporate earnings decline, all of which becomes visible in shrinking economic output data. But when would you call such development a recession? There is the common definition of two consecutive quarters of economic decline. The United States’ NBER  defines recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

This is not just showing that there isn’t any official definition narrow enough to delineate the entry points into and out of a recession, which you would justifiably dismiss as quibbling. The problem is how official institutions, such as governments and central banks, can identify when an economic downturn starts to perpetuate. When it has become a cycle which is, simply put, marked by declines in consumption and investment triggering declines in production, triggering jobs cuts, triggering declines in consumption and investment and so on.

The second important aspect, as discussed, is that different economies are each exposed to price pressure effects in a different manner so that the causes of their inflation, the relevant fiscal and monetary policy countermeasures and the degree of them sliding into recession will vary, too. So, by some metrics, some regions are in recession already while others will follow and yet others might not at all. According to the latest IMF report, the labour markets in economic areas such as Europe, including the United Kingdom, and the United States have remained extremely resilient. In the United States, the inflation rate has been falling since July and it has started to come down in the Eurozone as well in line with falling energy prices. In my view, a global downturn of significant size and tenor is all but on the cards.