Do you think the Fed’s task is difficult? At least the US Federal Reserve can focus on fighting inflation. In Japan and Europe, central banks are fighting markets, not just rising prices. This leads to very strange, even contradictory, policies.
The troubles of the three central banks mean that investors must prepare for the kind of low-probability, high-threat risk that leads to severe price shifts. When central banks unexpectedly head in the complete opposite direction, watch out. Let’s review the risks.
Fed It failed to stop inflation because it spent so much time looking back, as part of its policy of being “data-driven,” and thus kept rates very low for too long. By sticking to the data-driven spell, they risk repeating the error in the opposite direction, increasing the likelihood that it will cause the next recession and should lead to 180. With markets barely starting to price in the recession and thus falling in profits, that would hurt.
On Wednesday, Federal Reserve Chairman Jerome Powell went further, saying he would not “declare victory” over inflation until inflation has fallen for months. Since inflation usually peaks at the start of a recession or after it begins, this makes it difficult for the Fed to stop tightening.
Mr. Powell talked about empirically knowing what level of interest rates would slow down the economy enough. My reading of that is that the Fed has committed to keep going until something happens.
European Central Bank He has a familiar problem: politics. On Wednesday, the European Central Bank held an emergency meeting to address the problem of Italy, and to a lesser extent Greece. The European Central Bank wants to ease the escalating heat in Italian bonds, with the 10-year yield rising to 2.48 percentage points above Germany before falling after the ECB action.
Unlike a decade ago, when then-European Central Bank President and current Italian Prime Minister Mario Draghi pledged to do whatever it takes, the central bank’s action came before a fire broke out, which is commendable. But the temporary measure to redirect some maturing bonds bought as a pandemic stimulus to the troubled eurozone countries is relatively small.
The European Central Bank promised to speed up work on a “new anti-fragmentation tool” as a long-term solution, but here’s where it runs counter to policy. The rich North has long demanded terms in return for an injection of money into troubled countries, to ensure that low bond yields are not used as an excuse for more unsustainable borrowing. But until the economy is engulfed in flames, troubled countries do not want the embarrassment — and political disaster — of accepting oversight from the IMF or the rest of Europe.
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It will be difficult for the European Central Bank to buy bonds in Italy to keep yields low while raising interest rates elsewhere. At the very least, it will have to impose a much tougher policy on other nations than it would otherwise. At worst, it will take on the existential risk that Italy could one day default, as Greece did, crushing the ECB’s finances. Both are politically toxic.
At the moment, the problem of inflation in Europe is different from the problem of the United States, in that wages are not accelerating. But if Europe follows the US, interest rates may be forced to rise so much that slow-growing Italy will struggle to pay interest on its government debt, which is 150% of GDP, no matter how much the European Central Bank puts pressure on the Italian spread. German bonds.
Even a small risk of Italy getting into trouble justifies a flood of its bonds, where higher yields become self-fulfilling. When higher yields increase default risk, they make bonds less attractive rather than more attractive. Left to itself, the market will continue to push it higher in an endless spiral.
Bank of Japan Markets are also fighting, although they have a better chance of winning than the European Central Bank. Investors have been betting that the Bank of Japan will have to raise the ceiling on bond yields, known as yield curve control. In principle, the Bank of Japan can buy unlimited amounts of bonds, so it can maintain the maximum if it so desires. But if investors believe inflation justifies higher yields, the Bank of Japan will have to buy ever-increasing amounts of bonds, because investors won’t, as the late economist Milton Friedman pointed out in 1968.
Japan has the best case of any major developed country for easy monetary policy. While inflation has crossed 2% for the first time since 2015, almost all of this is due to rising global energy and food prices, and there is little pressure to raise wages. Excluding fresh food and energy, annual inflation was 0.8% in April, hardly a reason to panic.
However, inflation is on the rise, and the risk is rising to which the Bank of Japan will have to succumb, leading to a gradual change in bond yields – the kind of shift that could tear markets apart globally. When the Swiss central bank ditched its currency ceiling in 2015, many hedge funds that bet they would stick to their guns took a hit, and some were forced to close. Japan is several times more important than Switzerland, which rattled the currency markets last week with unexpectedly hawkish interest rate hikes that sent the franc soaring.
All this gloom can be avoided — central banks are very smart. But big errors are more likely than they used to be, which means that the risks of extreme events in the markets are rising. This calls for caution on the part of investors.
Write to James Mackintosh at email@example.com
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