(Bloomberg) — The end of easy money is upon us.
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Two years after the pandemic plunged the global economy into a deep but short recession, central bankers are withdrawing their emergency support – and they are moving faster than they or most investors anticipated.
The US Federal Reserve is preparing to raise interest rates in March, and last Friday’s jobs report fueled speculation that it may need to act aggressively. The Bank of England just made back-to-back hikes, and some of its officials wanted to act even more forcefully. The Bank of Canada is expected to take off next month. Even the European Central Bank could get in on the action later this year.
Rates are rising because policymakers judge the global inflation shock now poses a bigger threat than further damage to growth from Covid-19. Some say it took them far too long to come to this conclusion. Others fear the hawkish turn could slow recoveries without offering much relief from high prices, given that some of the surge is tied to supply issues beyond the reach of monetary policy.
There are a few outliers among the biggest economies.
The People’s Bank of China seems to be heading in the opposite direction. Credit is likely to be cheaper as further virus outbreaks and a housing slump cloud the outlook for the world’s second-largest economy. And the Bank of Japan is expected to keep its policy unchanged this year, although traders are starting to wonder if it can hold the line.
In emerging markets, many central banks started raising rates last year – and have yet to do so.
Just last week, Brazil recorded a third straight rise of 150 points, while the Czech Republic lifted its benchmark index to the highest in the European Union. Mexico and Peru are expected to extend their tightening campaigns this week, although some believe the Latin American cycle could peak.
Economists at JPMorgan Chase & Co. estimate that by April, rates will have risen in countries that together produce about half of the world’s gross domestic product, up from 5% currently. They expect a global average interest rate of around 2% at the end of this year, roughly the pre-pandemic level.
All of this suggests the biggest tightening of monetary policy since the 1990s. And the change is not limited to rates. Central banks are also reducing bond-buying programs they have used to limit long-term borrowing costs. Bloomberg Economics calculates that the combined balance sheet of the Group of Seven countries will peak by the middle of the year.
“The tables have turned,” Aditya Bhave, an economist at Bank of America Corp., wrote in a report released Friday. “The surge in global inflation has pushed cycles of central bank hikes and balance sheet contraction across the board.”
In the process, the pivot may end up ending a pandemic boom in financial markets that has been amplified by free money.
The MSCI World Equity Index is down about 5% this year. Bonds plunged around the world, pushing yields higher.
What forced the central bank to rethink was a wave of inflation. It is driven by a disconnect between growing demand in post-lockdown economies and supply shortages of some key products, materials and goods – as well as workers.
This week, the United States is expected to post an inflation rate of 7.3% for January, the highest since the early 1980s. Inflation in the euro zone has just reached a record high.
Just a few months ago, most managers did not anticipate the situation in which they now find themselves. They have spent much of 2021 arguing that price pressures will prove to be “transient”. They welcomed the rapid rebound in employment and dismissed the inflationary alarms that some commentators were already sounding.
Today, policymakers have decided that inflation has power and that tolerating it risks triggering an upward spiral in prices and wages, which may prove impossible to stem without triggering a recession.
By acting now to calm things down a bit, they hope to deliver a legendary “soft landing”, instead of a crash.
There are risks both ways.
According to JPMorgan economists led by Bruce Kasman, inflation will likely continue to be stoked by falling unemployment and renewed demand for services as economies resist the omicron variant. “We find it difficult to accept a juxtaposition of sustained low inflation with limited central bank action,” they also said in a report.
Some leading economists and investors warn that central banks are still “behind” and do not fully grasp the scale of the measures they will need to take.
But rapid increases now could be counterproductive if inflation starts to wane as supply chains heal and commodity markets cool. That could leave the political parameters suddenly looking too tight – which happened to the ECB a decade ago.
And if inflation persists, it may not be the kind that can be managed with monetary policy.
BlackRock Inc. strategists say prices are rising faster due to supply issues, and central bankers should learn to live with that. Bloomberg Economics calculates that if the BOE wanted to bring inflation back to its 2% target this year, it would have to raise rates enough to put 1.2 million people out of work.
For now, the only way is to raise global rates – but beyond that the details are hazy.
Forecasts differ widely on the number of Fed hikes to come this year. While Barclays Plc is counting on just three hikes, for example, Bank of America is expecting seven. It’s also unclear how big the moves will be, when they’ll be executed and where the benchmark rate will eventually end up.
Central bankers prefer it when their intentions are widely understood. After making a sudden change in policy, they must figure out how to communicate their new plans to investors. Otherwise, the markets could be mistreated.
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