In January 2022, the IMF predicted a year of low growth with high inflation. Since then, the IMF has twice lowered its projections giving a gloomy outlook for global growth. OBELA estimated that the FED and the European Central Bank were in a dilemma where they would either ride with high inflation and some recovery or use the conventional monetary instruments of raising the interest rate and knock down the fragile consumption and investment dynamics to bring down inflation. There was a difference between the Fed having a monetary problem and the ECB recognising the geopolitical inflation issues. The result has been that both decided to raise interest rates and reduce liquidity, with predictable consequences.
On June 15, the Fed raised its target interest rate by 75 basis points, the most substantial increase since 1994. The rate has already reached 1.75%, the pre-pandemic level. It does not seem to be enough; the expectation is that it will get 3.5% by the end of the year. Meanwhile, political and media discourses are looking for who to blame for the highest inflation rate in the last 40 years. A recession comes next.
The annual inflation rate in the US reached 8.4 % in March 2022, the highest in four decades. Latin America shudders at the memory of how Governments controlled inflation then. Are there conditions for a new Volcker shock? What is different four decades later?
“If your only tool is a hammer, every problem looks like a nail”. Still haunted by the clever preaching of monetarist guru Milton Friedman’s ghost, all too many monetary authorities address every inflationary threat or sign they see by raising interest rates.
Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” still defines the orthodoxy. Despite changed circumstances in the world today, for Friedmanites, inflation must be curbed by monetary tightening, especially interest rate hikes.
As 2022 progresses, the economic growth/stock markets/inflation control trilemma that we have already discussed becomes more evident. Now we start to look at central banks' decisions and analyse how these will impact growth and financial markets.
Recent statements by Christine Lagarde, President of the European Central Bank (ECB), say that post-confinement inflation remains outside their influence. Its sources are the recovery of demand and border upheavals, she says. The ECB, like the Fed, combats the economic effects of the pandemic with large injections of liquidity into the markets and improvements in financial conditions. However, the latest monetary policy statement left aside price stabilisation, its only mandate. Does this mean that the ECB will sit back and watch inflation decimate purchasing power?
The monetary policy responses to the economic and health crisis due to covid-19 were to lower interest rates, the historical amounts of liquidity injected by central banks, and loans to the financial sector.
The implemented monetary policy, known as "quantitative easing", had the objective of halting the fall of the stock market, stimulating consumption, investment and employment which, in turn, would favor economic recovery.
The upcoming normalization of monetary policy will be a challenge for central banks. The experience gained with the 2008 crisis shows that normalization is a medium and long-term policy and there is uncertainty about what, how and when it will be.
Globally, inflation closed 2021 at its highest level in the last twenty years (40 years in the case of the US) and projections indicate that during 2022. However, even if it is lower than last year, we will continue to see it high in 2022. Why is it a top concern for governments, central banks and consumers?
Governments are concerned that central banks will speed up the normalization of interest rates in the face of high inflation rates. This would put a brake on economic recovery and job creation and, in some cases, would cause the deterioration of the fiscal balances of some countries that acquired debt to mitigate the effects of the economic contraction or slowdown.
The strategies followed by governments and central banks to control inflation will determine the economic conditions of the coming years and the ability of the world to recover from the economic contraction of 2020.
Since economic activity resumed after the lockdowns, high rates of inflation have been observed around the world, although some monetary authorities have indicated that it is transitory. . The integration of global value chains, the magnitude of international trade and the productive and financial interdependence have shaped this post-confinement inflation.
Inflation is far from transitory, companies are facing a combination of supply chain challenges, as well as higher costs for energy, raw materials, packaging and shipping, all while becoming one of the biggest concerns of consumers around the world.
Central banks have taken a more aggressive stance. US Fed officials accepted that high inflation, which has risen to 5 percent, will be long-lasting. These measures are contractive, contrary to the much desired recovery of the product.
The reasoning of modern monetary theory holds that countries with reserve currencies can maintain unlimited levels of fiscal deficits and public debt because they have financing available. The evidence, however, shows that massive deficits do not mean economic dynamism in the US.
After 2008, federal deficits have doubled from about 60% of GDP to about 120%. Emerging nations shift their resources to China through the US deficit instead of growing, since the world is one and the borders are all open, and trade is unrestricted.
US debt in nominal amounts is more than that of the rest of the world combined. So monetary inflation exists and hits first the most deficit countries, then the least, and finally the rest of the world as imported inflation.