Economy · August 5, 2022

Paying dearly for central bank money creation

Much of the damage to bond and stock prices that we expected this year has been done. Markets are rapidly adjusting to a new world characterized by higher inflation in the more advanced countries. They are getting used to the need to raise interest rates to combat rising prices by slowing down economies.

The markets were ruled by the major central banks. Studying them was fundamental in looking to the future of economies and financial activities.

Asian markets were led by China and Japan, which managed inflation well, keeping it at around 2.5%, despite being exposed to sharp spikes in energy and food costs. Both also exercised reasonable control over their money supply and credit during the Covid lockdowns, with the People’s Bank of China maintaining its monetary target.

By contrast, major Western central banks – the Federal Reserve, the European Central Bank and the Bank of England – have neither targeted nor worried about money and credit, actively promoting major expansion to offset the impact of the blockades. and general disruptions in the supply chain activities. Each of them continued the push to create money until the recovery and found themselves with double-digit inflation.

The Fed has provided the biggest boost to its economy and has decided as of the second quarter of this year to end all money creation, reduce its bloated balance sheet and aggressively raise interest rates from ultra-high levels. low to show its determination to suppress inflation. This led to a strong sell off of bonds and many stocks, especially the long bull market growth successes.

The Bank of England was the first to put an end to money creation, stopping it last December. It is now trying to balance the need for higher rates to counter inflation with the risk of it being so harsh that it will cause a recession next year, choosing Thursday to raise its main interest rate by 0.5 percentage points.

However, the central bank with by far the biggest headache is the ECB.

I kept the FT fund out of continental stocks for a variety of reasons, plus a small indirect exposure through holding the world index. The EU economy suffers from an energy shortage, exacerbated by Russia’s violent invasion of Ukraine and the need to divert Russian energy from Europe’s sources of supply.

It has been harmed more directly by war and sanctions than the United States. When it comes to climate change, it has embarked on a vigorous net zero path which means shutting down or adapting many of its more traditional industries.

The euro area is still divided between the surplus countries that generate more euros from trade and economic success and the deficit countries that are short of currency and need more loans. The original euro scheme had strong Germanic elements. Each Member State had to keep its budget deficit under control and was responsible for its own indebtedness. The central bank is not authorized to assist Member States in financing excessive deficits. Deficit countries needed to cut spending or raise taxes.

Today there are many who want to loosen these rigid rules. The need to keep government deficits at 3 per cent and public debt at 60 per cent of GDP suspended. The surpluses of Germany and some others are deposited with the ECB, which lends them to deficit countries at zero interest rates to ensure smooth settlement within the zone.

The ECB is discussing how to ensure the transmission of its policy across the area. This is an elegant speech to try to keep lending rates lower for long- and shorter-term loans at similar interest rates across all member states.

The ECB sets the same short-term interest rate for the entire zone, but does not set the rates at which individuals and companies can borrow from commercial banks in different countries and cannot set the rates that states must pay to cover. your loan bills for longer periods.

He is concerned about how Italy’s cost of borrowing is well above Germany’s. He wants to avoid that the heavily indebted Italian state has to pay too much for new loans and that he finds himself in financial difficulties with his huge interest.

Over the two decades, Italy has been in the euro, has not been able to lower its public debt and remains well above the required figure. The EU is now trying to assist Italy by sending much of the central EU’s recovery funds to reduce Italy’s need for debt. These funds are raised as debts of the EU.

The ECB continued to create money and buy bonds until the end of June, before ending its bond purchase programs. There are now five countries in the area with inflation above 10%.

However, he is concerned about the current sluggish performance of many national economies and wants to be able to buy bonds from deficit countries to prevent their rates from getting too high. This is likely to prolong the political confusion in trying to accomplish the near impossible task of preventing recession, stopping inflation and keeping bond rates together, all at the same time.

I continue to look for ways to get a better return from the consistent liquidity the fund has used as markets increasingly recognize future strains.

Sir John Redwood is Charles Stanley’s chief global strategist. The FT Fund is a fictional portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global equity markets while keeping investment costs low. john.redwood@ft.com