Strategy blog: Monetary proportion
Strategy team: Kevin Gardiner
Central banks are supposed to keep inflation low. If inflation is caused by growth being too fast, then they may have to slow growth down. This could push unemployment up.
Monetary policy focused only on keeping inflation down might deliver unacceptably high rates of unemployment. To stop that happening, central banks target unemployment too – formally, in the case of the Federal Reserve (whose success is judged by Congress), and informally in the case of the ECB and the Bank of England (who are judged in the court of public opinion).
How are the big three Western central banks doing currently? Since February 2020 (that is, before the pandemic closures), CPI inflation has risen by 5, 4 and 3 percentage points respectively in the US, eurozone and UK, and is way above target in each case. Over the same period, US, eurozone and UK unemployment rates are unchanged (to the nearest percentage point), at historically low levels.
Meanwhile, official US and UK interest rates have fallen to historic lows. Eurozone rates are unchanged, but were at historic lows to start with. Alongside low interest rates, the big three have bought trillions of dollars' worth of bonds between them.
So: inflation has surged, unemployment has not risen, but monetary policy has loosened.
If unemployment had risen sustainably as a result of the pandemic closures, looser monetary policy might make sense, despite the surge in inflation: we would be tolerating one Bad Thing (inflation) in an attempt to reduce the increase in another (unemployment). But as it stands, the Fed, the ECB and the Bank appear to have elevated the pursuit of low unemployment above that of low inflation.
This is a simplification of course. The big three – like many other commentators – can argue that much of the inflation will be short lived, that low unemployment has taken them by surprise, and that financial markets might be unsettled by too rapid a tightening. They might even argue that received wisdom, which takes for granted that trade-off between stable prices and economic growth, is mistaken. We'd agree, mostly (we think low unemployment ought not to have surprised them).
But at some stage the details and qualifications have to be put aside. One of today's buzzwords is "proportionality". Is the monetary risk central banks are taking by not acting more decisively proportionate to any benefit gained?
We expect the Bank of England, and soon the Fed too, to deliver a steady stream of rate rises (and more restrained balance sheets) through this year and next as they increasingly recognise the threat to monetary credibility, and act to reduce it.
Today's decision by the Bank to raise its policy rate a second time in the post-pandemic period (from 0.25% to 0.5% – as noted, still a historically-low level) should be seen in this context.
We would not be surprised if the ECB also were to smell the coffee soon, despite their inaction today.
More normal monetary conditions might well deliver more market volatility but that should not stop central banks from trying to deliver them, and stocks remain our preferred asset. Expectations for US corporate earnings in 2022 – up a further 2% since year end – may still be too low.
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