There’s more than inflation: It’s time for central bankers to face the music

The sole focus of central bankers over the past year has been on inflation. But there will come a point, probably in the not-too-distant future, where they might have to widen their gaze.

The minutes of the Federal Reserve Board’s June meeting are a case in point. The discussion was predominantly about whether the federal funds rate should be raised for the 11th successive time at that meeting, or whether there should be a pause before the next move up.

Fed chair Jerome Powell’s main focus has been on battling inflation, but was it too much?
Fed chair Jerome Powell’s main focus has been on battling inflation, but was it too much?Credit: AP

The arguments for a pause won out, but almost all 18 members of the committee agreed more tightening would be needed this year, with the projections that were released after the meeting showing most expect at least two more 25 basis-point rises.

While the central bankers fixate on inflation, and “core” inflation (excluding food and fuel prices) in particular, there’s less attention being paid to the potential consequences of raising rates so aggressively in such a relatively short time frame.

The Fed’s minutes contain a staff’s review of the “financial situation” that contains a pretty routine and sanguine discussion of the impact of the tightening of conditions on markets, banks and companies.

Banks’ ability to fund loans, for instance, had stabilised after the regional bank crisis earlier this year, with deposit outflows slowing. Funding in capital markets had been resilient, although there were some signs of strain in leveraged loan markets and tighter availability of credit for small businesses.

Here in Australia, in the statement Philip Lowe released after the Reserve Bank meeting this week, where the bank also paused its run of rate rises, there were references to the impact of higher interest rates on households. But nothing meaningful was said about the conditions for small businesses or the state of financial markets.

While this outbreak of inflation is usually attributed to the pandemic and the shocks to global supply chains it generated, the root causes of the current challenges lie deeper and began germinating about a decade and a half ago.


The low inflation era that preceded the pandemic was characterised by financial liberalisation, globalisation and the emergence of China as the world’s low-cost manufacturing platform.

The era of low inflation was prolonged by central banks’ responses to the 2008 financial crisis, where interest rates were set at unprecedented low levels, in some case at negative levels, and central bank balance sheets expanded to levels not experienced in the post-war period as the banks deployed unconventional policies.

It is obvious (with the benefit of hindsight) that the central banks and governments’ response to the pandemic was too large, too broad-based and too long-lasting.

Those settings of ultra-low rates and ultra-loose credit conditions remained broadly in place until the pandemic struck, upon which the central banks doubled down with lower interest rates and doused markets and institutions with even more unconventional and cheap liquidity. Governments provided a deluge of free cash to households and businesses.

While understandable, it is obvious (with the benefit of hindsight) that the central banks and governments’ response to the pandemic was too large, too broad-based and too long-lasting – a criticism many would also make of the banks’ maintenance of their post-2008 monetary policy settings.

It’s not surprising that from 2009 the availability of cheap credit saw huge surges in asset prices and a massive increase in global debt at every level. Nor is it surprising that, once the initial shock of the pandemic wore off, markets responded by bouncing back.

The legacy of that post-2008 era, compounded by the way governments, businesses and households responded to the pandemic, is a lot of debt.

The global debt-to-GDP ratio in the lead-up to the global financial crisis in 2008 was just under 200 per cent. In 2020, it rose by 28 percentage points to 256 per cent of GDP, according to the International Monetary Fund. Last year, it eased slightly but still ended the year at 247 per cent.

That level of leverage is serviceable when rates are close to zero and economic conditions are benign. It’s a lot less comfortable when policy rates are around 5 per cent and still climbing, and global growth is slowing.

While international institutions like the IMF and the World Bank do talk about financial fragility and the strains in developing countries’ finances, where a wave of debt restructuring has begun, there’s not been as much discussion about the general fragility and vulnerability of the financial system as a whole as rates rise and liquidity is sucked out.

Given that this cycle started more than a year ago, it’s from now on that you’d expect to see more collateral damage.

That’s despite a number of early warning signs – the near-collapse of the pensions sector in the UK, the run of regional bank collapses in the US and the forced takeover of a bank of global systemic importance, Credit Suisse, being the most obvious and visible.

More recently, the crisis around the UK’s largest water and sewerage utility Thames Water, which may have to be bailed out by the British government if its existing shareholders and lenders can’t restructure its $27 billion of debt, points to the stress the rapid rise in interest costs is imposing on leveraged entities.

Governments, businesses and households weren’t prepared for such a large increase in interest costs in such a short period, which makes it probable, rather than possible, that there will be more unintended consequences from the central bankers’ single-minded fight against inflation the longer it goes on.

Just as there are lags between actions taken by central banks and their impact on inflation rates – generally assessed as being between 12 and 18 months – there are similar delays before their impact on businesses and households becomes evident. Given that this cycle started more than a year ago, it’s from now on that you’d expect to see more collateral damage.

The Fed and the RBA have paused their rate-hiking for a month to take stock of the effects of their policies to date, but both appear determined to do whatever it takes, regardless of the unintended damage that might do, to return inflation to pre-pandemic levels.

Given the leads and lags in monetary policy and how far inflation rates remain above the central banks’ targets, this is probably still going to end in over-kill, with a lot more unintended and painful consequences for markets, businesses and households before this cycle of inflation ends and a cycle of significant financial instability begins.

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