Monetary Policy Tightening in Vogue - Will it be the Monetary Pandemic that will disrupt the Post-pandemic Recovery of the Global Economy
Pandemic Monetary Policy
At the onset of the Coronavirus pandemic at the beginning of
2020, central banks led by the Federal Reserve (Fed), Bank of England (BOE) and European Central Bank (ECB) started flooding the economies
with money (historic loosened monetary policy) to bailout the credit systems shattered by the pandemic. This monetary policy consisted of two main
instruments, i.e., keeping interest rates around zero and printing money lavishly through the purchase of government and private securities from the market. In
addition, it relaxed regulations on bank lending to facilitate deferment of
repayment of loans by borrowers caught in the pandemic and expansion of credit
to businesses and households to survive the pandemic.
This pandemic monetary policy primarily helped governments
to fund their historic public stimulus programs at close to zero interest rates
for the recovery of businesses and households from the pandemic. There is no
controversy over this direct and fast benefit of the pandemic monetary policy to
the global economy and public.
All central banks did this by leaving out their
long-believed hypothesis of monetarist inflation. No mainstream economists
raised any concerns over possible inflationary pressures predicted in the
conventional monetarist model. The Fed Chairman in response to a media question
over possible inflation responded that the Fed was not concerned about the
hypothesis of future inflation and debt sustainability that can be addressed,
if necessary, after the recovery from the pandemic. No central bank predicted
such problems as they were single-minded on speedy recovery of spending to
fast track the recovery of growth of pandemic-hit economies.
The only path immediately feasible to central banks for this
purpose was to fund the government, given the catastrophic spread of the
pandemic and its socio-economic damages across the globe. They also attempted a
sort of supply chain financing through the banking system, but their
effectiveness is still not reported. In addition, the flooded money policy may
have helped protect the financial stability as abundant spread of money in
money markets may have prevented a possibility of liquidity crunch arising from
uncertainties attached to the pandemic and herd behaviors.
However, the mostly reported outcome of the pandemic
monetary policy is the massive increase in government debt supported by new
money printing which has helped early recovery of spending and economic growth.
If not for such a pandemic monetary policy, the global economy and living
standards could have confronted the worst depression in the history.
Subsequent Macroeconomic Developments and Issues
Although fiscal and monetary policymakers expected that the
growth and employment would recover steadily supported by the policy stimuli on
demand side of the economy, the supply side disruptions caused by the pandemic
lockdowns and continuous uncertainties have resulted in unexpected imbalances
in all markets. The initial damage to the production capacity and inventories,
especially on the agriculture and service sectors, and resignation of labor
from organized markets and intuitional sector have caused diverse supply chain
problems across the globe. At present, people confront enormous difficulties in getting their needs satisfied because of supply chain problems.
Therefore, supply side bottlenecks have slowed the growth recovery
and overshot the inflation at historic highs. The interim change in the
consumer demand pattern sifted from services consumption towards food and
durables also has fueled consumer inflation covered in consumer price
indices. The pandemic fiscal and monetary stimuli have boosted the demand side
and spending while the supply chain problems have kept the supply side recovery
lagging far behind so far.
In this background, the monetarist inflation
hypothesis has reemerged and cites that present rising inflationary
pressures globally have been caused by historic monetary expansion that has
fueled the spending during the past two years. Those who believe in this inflation
hypothesis talk about the mismatch between the aggregate demand and the aggregate
supply in the economy (the demand being greater than the supply) and money
being the source or the conduit between the two sides causing the mismatch
through the aggregate demand.
Therefore, pro-monetarists are not prepared to accept supply
side bottlenecks created by the pandemic as the source of present inflationary
pressures emanating from various markets. Further, a major part of the monetary
expansion still remains idle as bank excess reserves mostly held with central
banks and, therefore, monetarists see the risk of such reserves turning into credit in the near future
causing further spending and inflationary pressures.
Therefore, central banks who generally adhere to monetarist
versions of macroeconomic diagnosis and prescriptions now seem to embark or
send signals on monetary tightening path ahead to fight the inflation. The
tightening phase implies raising interest rates and removal of a part of new money
already printed and circulating in the economy.
Herd Behavior of Money Market Speculators
Speculative money market dealers also provide a strong
helping hand to central banks to move on the tightening path. As they are
speculative profiteers, they tend to drive money market interest rates and
prices based on inflation expectations formed by them in a network or herd
bahaviour. Given the conditions of present supply side bottlenecks, rising
inflation numbers and excess monetary liquidity, they expect continuing
inflationary pressures and, therefore, add an inflation risk premium to market
interest rates on their deals so that the present level of real
interest rate (even though mostly negative) is protected.
This results in lowering the market prices of securities/assets
such as stocks and bonds as interest rates and securities prices are inversely
related in general. Further, such speculative elements also predict a path of
the monetary tightening, mainly central bank policy interest rates, and price
their credit and securities dealings accordingly.
If the reported inflation is rising continuously over a
period of time, the increase in interest rates in short-term money markets is
transmitted to long-term credit markets and real sectors too. In that context,
if the credit channel is effective on spending and inflation as predicted in
the monetarist model, markets themselves will tackle the inflation overshooting
with a time lag without a support from the monetary policy.
For example, high interest rates will reduce demand for
credit and economize spending. Further, higher prices will reduce spending
(Pigou effect) and lower prices over time. The Fed Chair at the last monetary
policy press conference held on 27 January 2022 stated that as the monetary
policy works significantly through market expectations, market participants
behaving through speculation on possible monetary policy actions is
appropriate.
Why Monetary Policy is called upon to tame inflation
If markets have own process to tackle inflation, why should
central banks also tend to tighten the monetary policy by leaning with the
market speculation need to be understood. The reason rests on the nature of
the present monetary policy models followed in many countries led by the Fed,
BOE and ECB. In general, central bank policy interest rates and money printing
are carried out to fund the inter-bank operations mainly on overnight basis. In
certain situations, short-term inter-bank credit operations such as 7-days and
one month also are covered to influence the overnight market. Therefore, policy
interest rates are the price targets set by central banks for overnight
inter-bank credit dealings.
Such interest rates targets are maintained through central
bank open market operations (OMO) covering overnight repos and reverse repos,
term repos/reverse repos, taking overnight deposits in cash from banks and grant
of overnight and short-term loans to banks against collaterals. Therefore, OMO
is the major source of money printing to support liquidity mismatches in bank intermediation businesses in the economy primarily based on the
policy rates. Therefore, OMO based money printing is the warehouse operated to
maintain central bank interest rate targets.
Therefore, if central banks do not revise upward their policy rates in line with money market interest rates, banks will be raising their arbitrage profit margins by borrowing at low policy rates from the central bank and using such funds for lending and investing businesses at rising market interest rates at a cost to central banks. This is the reason why banks globally have reported rising profit margins regardless of the pandemic-hit economies.
However, banks are not able to keep such profit margins on credit
operations that are run on central bank refinance funding as their credit terms
are fixed outside such market speculations. However, such refinance credit
operations are presently limited in volumes.
Therefore, central banks also are compelled to follow suit the
market trend of interest rates. In addition to OMO, central banks use statutory
reserve ratio on bank deposits (SRR) to directly control the liquidity in the
banking system. As such, policy rates, OMO (or short-term money printing) and
SRR are the so-called monetary policy tools or actions of central banks. Asset
purchases also fall within the OMO. They believe that effects of such policy
actions will be transmitted to wide spectrum of credit markets with varying time
lags to affect spending and prices/inflation in the economy.
However, other than conceptual explanations, no empirical
evidence is available to show that such monetary tools are correlated with
inflation or growth because markets respond to many shocks and uncertainties
including monetary and fiscal tools in a dynamic manner. Therefore, inflation
dynamics is not that simple to be driven by central bank/monetarist models.
Further, how the overnight inter-bank liquidity-based money printing model
drives inflation dynamics in market economies does not bear any common sense.
Line up of Central Banks for Monetary Tightening
Central banks having seen inflation beginning to rise at the
third quarter 2021 after experiencing historic lows during the past decade
commented that the inflationary pressures were transient on supply bottlenecks
caused by pandemic and would fade away soon with the complete reopening of
economies and recovery of global supply chains. This meant that monetary policy
tightening in the monetarist version was not required at that stage.
However, by November 2021, central banks started commenting
on continuously rising inflationary pressures as persistent than initially
expected and stated that they were prepared to invoke monetary policy tools as
appropriate to control inflation within their targets (2% in developed countries).
The Fed and ECB outlined their tightening path as the reduction in new money
printing by reaching at zero level of net asset purchases first and raising
interest rates next at appropriate time and sequence.
Accordingly, the Fed is now geared to discontinue its net asset purchase programme of US$ 120 bn per month by end of March 2022. The ECB plans to discontinue its net purchases under Pandemic Emergency Purchase Programme (PEPP) of Euro 1,850 bn by end of March 2022. Further, Asset Purchase Programme (APP) in operation since 2007/09 global financial crisis is expected to continue at reducing phase until the ECB starts raising its interest rates. Meantime, its long-term refinance operations (phase III) will continue as planned.
However, none of the two has communicated on their
preparedness to raise interest rates. The Fed states that it is ready to
consider raising interest rates from March 2022 if necessary while the ECB
states that it is not ready to raise interest rates before December 2022.
In contrast, the BOE raised the interest rates twice, i.e.,
by 0.15% to 0.25% on 15th December 2021 and by 0.25% to 0.50% on 2nd
February 2022. The BOE will continue asset purchases for government bonds at
£875 bn and corporate bonds at £20 bn and consider unwinding only the corporate
bond stock after the end of 2023.
Therefore, none of the three has communicated any firm plans
for shrinking their balance sheets or monetary bases from the present levels of
historic high whereas they will continue to reinvest maturity proceeds of
existing stock of assets. Therefore, these three central banks which drive the
global monetary system are in great confusion as to what the tools and path of
the monetary tightening should be pursued to fight the inflation.
Several central banks in other developed countries have
reduced their new money printing through asset purchases but declined to raise
interest rates. Meantime, several central banks in developing countries have
embarked blindly on aggressive tightening of monetary policy by raising
interest rates and aggressive mopping up of inter-bank liquidity, despite grave
macroeconomic difficulties being confronted.
All Fed, BOE and ECB expect inflation to come down towards the end of 2022. Several emerging market central banks also state that present inflationary pressures are short-term due to supply chain problems although demand side pressures also are contributory. If so, why central banks plan to tighten the monetary policy when inflation is expected to fall or short-term is questionable, given the fact that the effectiveness of the monetary tightening in general is not established.
Further, although monetary tightening is clear in the monetarist model, central banks provide diverse comments as to why the tools, quantum and phase of the tightening are different from peer central banks, primarily attributable to differences in country economies and incoming economic data flows. Some central banks who bear foreign exchange and debt management functions in addition to monetary policy have messed up the respective economies due to their inability to manage the respective functions at arms' length. Therefore, all central banks are in great confusion as to how the monetary tightening is pursued to tame inflationary pressures and its effectiveness.
All central banks state that their tools cannot help fixing supply chain bottlenecks. Some central banks state that they tighten the monetary policy to tame the inflation by controlling the demand side pressure separated from supply side bottlenecks driving the inflation. Nobody knows whether such central banks have tools with precision to handle such a macroeconomic surgical task to separate demand side from the supply side.
Some central banks state that higher interest rates will boost savings and deposits that will curtail spending and inflation. This is a very micro comment because deposits and credit are the two sides of the same monetary coin where monetary policy is expected to have macroeconomic effects through credit side.
The BOE Governor's request to labour markets to refrain from higher wage negotiations in response to present inflationary pressures is being highly criticized by markets as the wage negotiations are outside the mandate of the monetary policy.
If the monetary policy is clear in monetarist models, such confusions and country differences are unwarranted when central banks are to fight inflation. However, central banking is not the only game in town to stabilize the economy. There are many state and market players contributing to the macroeconomic stability more directly than central banks.
Why Monetary Tightening will be a Global Monetary Pandemic
A careful decomposition of price increases that have
contributed to surge in inflation shows that supply chain problems involved in
production, transportation, inventories and trade of commodities have
contributed to increased cost and shortages that have pushed the prices up.
Energy prices are the major driver of price increases. Wage increases
consequent to withdrawal of certain labor categories from the institutional
work force also have pushed the prices up.
Further, a large volume of monetary liquidity created by
historic monetary and fiscal stimuli still remains idle in bank excess reserves
without fueling spending or demand. Therefore, the recovery of the demand
during the past two years is largely on the use of the pre-pandemic monetary
liquidity.
Therefore, the present surge in inflation is a pandemic supply side phenomenon as against conventional monetary phenomenon which cannot be applied to the pandemic macroeconomic circumstances that are not covered in mainstream economics. In this context, drastic monetary tightening as predicted would be nothing but a monetary pandemic caused by central banks and speculative money dealers.
The macroeconomic consequences of the monetary tightening, some of which are stated below, will no doubt establish this view, given the economies struggling to recover from the pandemic-caused uncertainties and changes in markets.
- Fiscal spending and deficits cannot be expected to slow down in the next decade. Therefore, a significant increase in cost of public debt will cause debt crises and put pressure on public to incur in higher taxes. This may cause widespread political instabilities that may endanger the recovery from the pandemic. It is predicted that the European Monetary Union runs the risk of breakdown as the monetary tightening will disproportionately affect member countries, especially highly indebted members such as Italy and Greece.
- The increase in interest rates and reduction in monetary liquidity and credit will add to supply chain problems causing more supply side bottlenecks and price escalations.
- The interest cost is a major component of the cost of production in present monetary capitalist economies. Therefore, monetary tightening will be a cost-push factor causing further rise in inflationary pressures similar to wage-price spiral. As the interest elasticity of credit demand is very low in credit-based monetary economies, any hike in interest rates will have chain effect on raising all prices in the economy.
- In the event significant tightening occurs in the developed world, capital outflows from emerging market economies would cause further supply chain problems affecting growth, employment, severe imbalances and uncertainties in the global economy. Some developing countries suffering from severe shortages of foreign currency reserves have tended to raise interest rates under the cover of inflation control with an elusive aim of encouraging foreign capital inflows. Foreign investors are not expected to take risks in such highly indebted countries in the present context of supply chain problems and global uncertainties.
- Monetary tightening is a root cause of financial crises exacerbated by systemic risks and governance lapses which are not generally detected by central banks and other regulators until the crises actually hit. It is highly likely that shortages of monetary liquidity created by the monetary tightening would cause financial panic conditions supported by supply chain bottlenecks.
The Urgent Need for New Monetary Policy Model
Therefore, central banks should abandon existing monetary hypotheses and monetary policy files in their offices and introduce a new monetary policy model of supply chain friendly credit distribution with a new approach of systemic macroeconomic risk management. Otherwise, policy tightening in the existing monetary model will question the sustainability of central banks in the next decade as they will fail in achieving all statuary objectives, i.e., economic stability, price stability and monetary/financial stability even on their targets.
In fact, the world is aggressively moving towards privately
managed monetary units in digital and other credit forms where present state
currency based monetary systems will face faster extinction if they fail to facilitate new societal needs.
Similar questions are being raised on state policies on other sectors as well due to catastrophic erosion of living standards of the general public in the present pandemic context. The global warming risk of rising above 1.5 degrees Celsius from the pre-industrial levels of 1840s is warned to be another pandemic on future generations. There is no argument that this is a fault of past generations in unhealthy use of the environmental resources. Therefore, all state policies including the monetary policy are now required to refocus their approaches and tools to prevent the climate pandemic.
(Next article will cover a proposal for design
features of a new monetary policy model to promote a fair distribution of economic
opportunities and benefits in largely market based economies with democratic beliefs)
P Samarasiri
Former Deputy Governor, Central Bank of Sri Lanka
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