High inflation has become the norm across the wealthy world. Retail inflation in the United States was 8.6% in May, the highest since December 1981. In the euro area, in countries that use the euro as their currency, retail inflation was 8.1% in May.
Controlling inflation has become our priority this decade Central bank. Central banks are doing two things – raising interest rates and doing quantitative tightening (QT). QT is the opposite of quantitative easing (QE), which central banks have been practicing since 2008.
In QE central banks print money and pump it into the financial system by buying bonds. This led to a dramatic increase in the total assets of central banks. QT is the opposite, where central banks attempt to withdraw money that is printed and pumped into the financial system.
This can be done in two ways. One is to sell the bonds that were bought and suck up the money printed. The second is to allow the bonds to mature and not reinvest the repaid money, leaving less money in the financial system. Between June and August, the US Federal Reserve plans to suck up $47.5 billion per month. After that, the plan is to suck up $95 billion per month. The Bank of England is letting the bond mature and is not redeploying that money. The European Central Bank (ECB) has called for an early end to QE.
How does this help? When a central bank raises interest rates, they raise short-term interest rates. But simply raising short-term interest rates is not enough to reduce consumer demand and, in turn, inflation. For that, long-term rates also need to be increased. Qt helps to do this, by taking money out of the financial system.
Morgan Stanley analysts expect the Federal Reserve, the Bank of England, the ECB and the Bank of Japan to reduce their balance sheets by around $4.2 trillion by the end of 2023 to control inflation. This will increase interest. rates and, in the process, lower consumer demand and lower inflation. Will that be enough, given that inflation expectations are pretty well grounded? Surveys show that people expect prices to continue to rise at a rapid pace over the next one year. So have firms that have been negatively impacted by higher commodity prices. In such a scenario, higher inflation expectations may be factored into wage/wage demands and prices, making it difficult for the central bank to control inflation.
Usually, the way a central bank tries to handle such a situation makes the world at large aware of its seriousness about controlling inflation. But this is not happening.
As Alan Blinder, who was the Federal Reserve’s deputy chairman in the 1990s, explains, along with his co-authors, in a recent research paper titled Central Bank Communication with the General Public: Promise or False Hope? As central banks seek to communicate effectively with their wider public, the first step is seeing that at least some of its signals reach their intended recipients. are aware of monetary policy and relatively inattentive to news about it.
Therefore, inflation is well established in the prosperous world and given that central banks may find it difficult to control and, therefore, the US and other parts of the prosperous world may fall into economic recession.
As analysts at Nomura put it in a recent report: “We believe the mild slowdown that began in the fourth quarter of 2022 is now more likely.”
Clearly, rich-world central banks led by the US Fed let the low-interest-rate party go on for too long. In the process, the Fed forgot something that William McChesney Martin, who was the Fed’s chairman between 1951 and 1970, once famously said; The Fed’s job was to remove the punch bowl “just when the party was getting really hot”.