Paying a heavy price for central banks’ money creation
Much of the damage to bond and share prices we expected this year has been done. Markets are adjusting rapidly to a new world of higher inflation in most advanced countries. They are getting used to the need for interest rates to go up to combat price rises by slowing economies.
The markets have been ruled by the leading central banks. Studying them has been crucial to seeing into the future for economies and financial assets.
Asian markets have been led by China and Japan, which have managed inflation well, keeping it to around 2.5 per cent, despite being exposed to big surges 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 money target.
In contrast, the leading western central banks — the Federal Reserve, the European Central Bank and the Bank of England — did not target or worry about money and credit, while actively promoting a major expansion to offset the impact of lockdowns and supply chain interruptions on general activity. Each of them continued the money creation drive well into the recovery and have ended up with inflation nudging double figures.
The Fed provided the biggest boost to its economy, and has decided from the second quarter of this year to end all money creation, to reduce its bloated balance sheet and raise interest rates aggressively from ultra low levels to show its determination to stamp out inflation. This has led to a sharp sell off in bonds and many shares, especially the growth successes of the long bull market.
The Bank of England was the first to end money creation, stopping it last December. It is now trying to balance the need for higher rates to tackle inflation against the risk of being so tough as to cause a recession next year, choosing on Thursday to raise its main interest rate by 0.5 percentage points.
However, the central bank with by far and away the biggest headaches is the ECB.
I have kept the FT fund out of continental shares for a variety of reasons, other than a small, indirect exposure through holding the world index. The EU economy is suffering from an energy shortage, made far worse by the violent invasion of Ukraine by Russia and the need to take Russian energy out of Europe’s supply sources.
It has been damaged more directly by the war and sanctions than the US. On climate change, it has embarked on a vigorous net zero path which means closing or adapting a lot of its more traditional industries.
The euro area is still split between the surplus countries generating more euros from trade and economic success, and the deficit countries short of currency and needing to borrow more. The original euro scheme had strong Germanic elements. Each member state had to keep its own budget deficit under control and was responsible for its own borrowing. The central bank is not allowed to assist member states in financing excessive deficits. Countries in deficit needed to cut spending or raise taxes.
Today there are many wishing to ease these strict rules. The need to keep state deficits to 3 per cent and state debt to 60 per cent of GDP have been suspended. The surpluses of Germany and some others are deposited in the ECB, which lends them on to the deficit countries at zero interest rates to ensure smooth settlements within the zone.
The ECB is debating how it can ensure the transmission of its policy throughout the area. This is posh talk for trying to keep borrowing rates lower for longer and shorter term loans at similar rates of interest in all the member states.
The ECB sets the same short-term interest rate for the whole zone but it does not set the rates at which individuals and companies can borrow from commercial banks in different countries and it cannot set the rates states have to pay to cover their own bills by borrowing for longer periods.
It is worried by the way Italy’s cost of borrowing is well above Germany’s. It wants to avoid the heavily indebted Italian state having to pay too much for new borrowing and getting into financial difficulties with its large interest bills.
Over the two decades Italy has been in the euro, it has been unable to get its state debt down, and it remains far higher than the required figure. The EU is now trying to assist Italy by sending a large portion of central EU recovery funds to reduce the need for Italy herself to borrow. These funds are being raised as EU debts.
The ECB continued to create money and buy bonds until the end of June, only then ending its bond purchase programmes. There are now five countries in the zone with inflation above 10 per cent.
It is, however, worried about the current sluggish performance of many of the national economies, and wants to be able to buy the bonds of the deficit-burdened countries to stop their rates going too high. This is likely to prolong the policy muddle in seeking to bring about the almost impossible task of preventing recession, stopping inflation and keeping bond rates together all at the same time.
I continue to look for ways to earn a better return on the substantial cash the fund has been running, now that markets recognise more of the stresses ahead.
Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. john.redwood@ft.com
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