Leading Central bankers and other experts will meet in Jackson Hole next week from Thursday to Saturday to review progress with fighting inflation and to ponder possible recession. The title of the symposium is “Reassessing constraints on the economy and policy”. The true agenda is likely to be have they done enough to get on top of an inflation they were not expecting? How far should they go in raising rates and reversing the massive bond buying most of them undertook over the last two years?
Some introspection and retrospection is called for. The Fed and the ECB thought they could happily proceed with creating billions more dollars and euros to buy ever more government bonds to add to their portfolios. As their balance sheets swelled with government paper, so interest rates for longer term as well as short term borrowing were kept close to zero. There was a feeling in Central Bank circles that the risks were all on the downside, that only excessive money creation could see off recession and avoid deflation. What was a necessary and major response to lockdown in 2020 became an extended experiment with large monetary stimulus which some think helped fuel the subsequent inflation.
The Central Banks that have presided over target smashing inflation rates tend to the view that a series of bad accidents or events came along to cause the inflation. Russia’s war on the Ukraine caused strong upward moves in energy and some food prices in particular. The problem with this view is the inflation was running well above target before Russia made her brutal move. Inflation in Japan and Switzerland., also subject to world oil and food prices stayed around 2% after the invasion leading to some doubts over the preferred explanation for the general rise in the price level. The Fed and ECB have similar views of how to control inflation and both are under a simple target to keep it to around 2%. They both seek to forecast output and income and are interested in expectations. Neither is that concerned about growth in the money supply itself, which took off in 2020 and only started to come back under control in 2022 when the Banks abruptly changed their policy stance from easy to tighter.
Central to the discussions they will have should be the issue of Quantitative tightening. There is a general feeling amongst Central bankers who did expand their balance sheets by buying more and more bonds that they should rein this in. After all the main tool of monetary policy in the last two years was not official interest rates which remained around zero but the large buying programmes designed to get bond prices higher and therefore to drive longer term interest rates lower. This in turn boosted housing by keeping mortgage rates low, should have boosted commercial investment by allowing long term company borrowings at low rates, and boosted consumer purchases of bigger ticket items on borrowing. It certainly allowed companies to buy back more of their own shares and increase their financial leverage. The first round inflationary effects were largely confined to rises in bond and share prices. Later came increases in the prices of traded goods and services.
The Fed has said it wants to cut its bond holdings and balance sheet by around $95 bn a month from September. The ECB is ending all its Quantitative easing , though it is also working on a lesser programme of bond buying to sustain the prices of bonds issued by the more heavily indebted members like Italy to avoid the growth of too large a gap between longer term German and Italian borrowing rates. IT will continue to reinvest the proceeds from maturing bonds. The last time the Fed reined in its bond portfolio in 2018 it led to a sharp sell off in markets, another so called taper tantrum. The Fed backed off and moderated the policy. The Central Banks argue that they can afford to reduce their bond holdings because the commercial banks nave plenty of reserves and do not need the Central Bank to hold so much of the government bond issuance. More of that could be held by the private sector at the expense of their bank deposits. It may be that the Central Banks underestimate the impact of substantial quantitative tightening.
Governments have a lot of debt to sell in the next couple of years. Fiscal policy since April 2020 has been generous with a substantial gap between tax revenue and outlays. The ending of Central Bank buying will mean paying a higher interest rate to get the debt away. Were the Central Banks to turn into sellers of government bonds the difficulties would be increased. For the time being the main aim of the Fed and ECB is to end all new bond buying and to allow run off of the portfolios as governments have to repay bond debt on maturity.