With many Central Banks now more actively tightening monetary policy, financial markets have unsurprisingly been more unsettled in recent weeks. The dilemma for investors is obvious. Should they assume that policymakers are applying a gentle brake to a world economy that is barely breaching its speed limit and will now seamlessly guide it back to a more inflation-friendly speed? Or, are they slamming on the brakes far too hard, and far too early – and to mix the metaphors – now taking a sledgehammer to crack a nut?
To this scribe the risks are tilted toward the second scenario. There is little question that monetary policy is still accommodative and that a slow normalisation campaign is warranted as the world economy normalises in a likely post-pandemic adjustment phase. But a growing number of Central Banks appear to be of the view that inflationary pressures have been building because their monetary policies have been too loose. A more active tightening campaign is therefore deemed necessary in order to squeeze out these pressures. But as we argue in more detail below this strategy carries tremendous risks. And global economic and financial stability are in danger at present of being sacrificed somewhat unnecessarily at the altar of Central Banks' inflation-fighting credentials
This view is based on several messages from the analysis below. Firstly, that the inflationary pressures that have been building in recent months are globally - not nationally - rooted. Secondly, that those global pressures have largely been driven by COVID-related supply side congestion, not by excessively loose monetary policy and overheating demand. Thirdly, and to that last point, credit impulses in most major economies have moved into negative territory in recent months. That's not symptomatic of excessively loose monetary policy. Fourthly, nearly every major economy - including the US - is still operating below levels that would have been expected based on pre-pandemic trends. And that's not symptomatic of an overheating world economy. Finally, wage inflation in nearly every major economy is not yet even close to keeping pace with headline price inflation. Household purchasing power is therefore being significantly eroded even in the absence of tighter monetary policy and igniting recession risks as a result.
Globally-rooted supply side pressures
Let's start with those global roots and those supply-side roots. A recent paper from the Federal Reserve Bank of New York (see The Global Supply Side of Inflationary Pressures) assessed in some detail the recent evolution of inflationary pressures in the US and Euro Area. One of the key findings is that globally-rooted supply factors – including those that pertain to the price of oil - are very strongly associated with the levels of - and persistence of - recent producer price inflation across countries, as well as with consumer goods price inflation (see figures 1, 2 and 3 below). This is noteworthy because all major advanced countries have experienced a large rise in goods price inflation during the initial pandemic recovery phase. Services inflation in contrast has been more muted.
As the paper's authors additionally note if their analysis is accurate and the bulk of many major economies' inflation issues can be traced to global roots and to supply-side roots, it suggests that domestic monetary policy actions could have only a limited effect in containing inflationary pressures.
Figure 1: US goods price inflation has been highly correlated with goods price inflation elsewhere
Global