Contradiction or normalization: central banks at a crossroads (Note)

Purpose of the article: Faced with inflation reaching its highest level in more than 30 years in Europe and the United States, central banks intend to normalize their monetary policy and thereby abandon the unconventional policy tools widely used in the 2010s and more recently to deal with the COVID-19 crisis. The purpose of this article is to define what these intervention tools consist of and thus show that their use appears to be incompatible with the objective of fighting inflation.

Abstract:

• To address the 2008 crisis and its consequences, the major central banks adopted new unconventional intervention tools (minimum policy rates, forward guidance, asset purchase programs).
• In the 2010s, the prolonged use of unconventional monetary policies provided support for economic activity and financial markets.
• However, these tools are likely to lead to inflation, financial instability, and widening wealth inequality.
• Faced with sharply rising inflation since 2021, central banks must act in line with their primary mandate of maintaining price stability and are therefore now forced to normalize their monetary policy by abandoning unconventional intervention tools;
• In seeking to promote price stability without compromising economic growth and financial stability, central banks must act cautiously while avoiding the pitfall of pursuing two objectives that require contradictory means of action.

For nearly 15 years, the economic and financial systems of the major developed countries have benefited from artificially and sustainably favorable financing conditions thanks to the actions of the major central banks, in particular the Federal Reserve (Fed) in the United States and the European Central Bank (ECB) in the euro zone.

In response to the 2008 crisis and its consequences (notably the debt crises in Europe), the major central banks initially reacted by lowering their key interest rates. However, given the scale of the economic and financial crisis, monetary authorities sought to overcome the main limitation of conventional intervention tools: the « floor » (0%) level of key interest rates, or zero lower bound ( ZLB). Thus, in order to be able to increase monetary stimulus when key interest rates had already been reduced to zero, central bankers developed unconventional policy tools[1]. The main unconventional monetary policy tools used were: (i) forward guidance (FG); and (ii) asset purchase programs known as quantitative easing (QE) or large-scale asset purchases (LSAP)[2].

1) Principles of unconventional intervention tools

How does it work? The ZLB situation directly reduces the short-term financing costs of commercial banks to a level close to zero and therefore has a direct impact on the short end of the yield curve (i.e., the reference rates for short-term maturities). However, as they can no longer influence the price of money when it reaches its « floor, » central banks influence its quantity by implementing asset purchase policies. LSAPs mainly (but not exclusively) involve sovereign bonds (government debt securities). By regularly and massively repurchasing these securities on the secondary market, central banks support their price and thus automatically compress the level of risk-free interest rates across the entire term structure. The direct consequences of LSAPs are, on the one hand, an increase in the money supply (and central bank balance sheets) and, on the other hand, artificially reduced short-, medium- and long-term reference rates.

In addition, central banks use the FG to signal to economic agents, and in particular to financial markets, their intentions regarding the evolution of key interest rates and asset purchase programs. By signaling their intentions in advance, central banks hope to influence the expectations of economic agents, and more particularly those of market operators, so that the latter, through their interventions, do « the work instead of […] the central bank.«  Thus, by signaling—via its forward guidance—its desire to keep its key interest rate low for an extended period and/or its willingness to extend its asset purchase program as long as necessary, the central bank seeks to guide the actions of market participants by discouraging them, in particular, from short selling the targeted securities.

Since the 2008 crisis and the emergence of unconventional monetary policies, forward guidance has mainly been used to influence interest rates and support financial asset prices. However, forward guidance was also used very skillfully during the Fed’s normalization phase between 2014 and 2018 (gradual increase in key rates and reduction of its balance sheet). By essentially indicating that, despite tightening monetary policy, the Fed reserved the right to « adjust » its normalization policy, the US central bank was careful to send a message of support and reassurance to the entire economic world, and more particularly to market operators.

2) Policies incompatible with the fight against inflation

When used as part of an accommodative monetary policy, unconventional monetary policy measures (ZLB, FG, LSAP) have the dual effect of « guaranteeing » favorable financing conditions for financial markets and directly supporting the prices of assets targeted by purchase programs.

In addition, the additional amounts of money injected (counterpart to asset purchases)[6] are likely to be reinvested in risky assets (financial and real estate assets), whose prices will then be supported or even artificially inflated (risk of bubble formation and widening wealth inequality)[7]. Finally, it should be noted that the crushing of reference rates automatically increases the present value of future cash flows (coupons, dividends) and therefore tends to increase the financial value of assets (financial inflation).

Unconventional monetary policies have been effective in supporting both the financial system and the capacity of governments to intervene in times of crisis. In particular, the COVID-19 crisis in February/March 2020 once again highlighted the means of action available to central banks and their ability to limit the negative effects of a significant exogenous shock on the entire economic and financial system[8].

However, these tools are not without their flaws[9] and their prolonged or excessive use is likely to lead to both:

• an acceleration of inflation linked to an increase in the amount of money in circulation;
• financial instability resulting from both artificially low interest rates and asset purchase programs, which have the effect of artificially inflating the prices of financial and real estate assets.

3) Catching up with reality

In 2021, inflation suddenly accelerated, significantly exceeding the 2% target in most developed countries. The major central banks—led by the Fed and the ECB—were surprised by this new reality and initially justified their lack of response by citing the supposedly « transitory » nature of this acceleration in price levels, which they attributed to shortages (linked to the COVID-19 crisis) and rising commodity prices (particularly energy). The monetary authorities thus initially « ignored » the fact that the massive government aid and stimulus policies – fueled by overly accommodative monetary policies – were likely to create a demand shock (linked in particular to public spending and excess savings accumulated during the pandemic) at a time when the economy was experiencing an exogenous supply shock (shortages of intermediate goods and raw materials)[11].

In 2022, as new supply shocks emerge (war in Ukraine, China’s « zero Covid » strategy likely to cause further production disruptions) and price rises continue to accelerate (more than 8% in the eurozone and the United States), there is a risk of structurally and sustainably high inflation (significantly above its target). Even if the increase in the price of raw materials and certain intermediate goods were to slow down (base effect), the effect in terms of loss of purchasing power (or reduction in profit margins for businesses) would, in principle , be permanent (assuming equal income and as long as prices do not fall). Therefore, to offset the rise in prices and rebuild their purchasing power (or margins) in real terms, consumers will tend to demand wage increases (increased labor costs), while companies (to offset cost increases) will seek to raise their prices. In such a situation, the initial exogenous supply shock (combined with demand support) is likely to ultimately lead to a sustained acceleration in inflation through a « price-wage » spiral, itself fueled by expectations of further price increases in the future.

Faced with objectives that require contradictory courses of action, namely (i) price stability and (ii) support for the economy and financial markets, central banks are now at a crossroads.

4) Conclusion: normalization under constraint

Faced with the economic reality of inflation well above target, while the primary and main objective of central banks is price stability, monetary authorities are forced to abandon their overly accommodative policy[12] at the risk of jeopardizing their most valuable asset: their credibility.

Central banks must therefore adjust their monetary policy settings, in particular by abandoning both the zero lower bound (ZLB) and large-scale asset purchase programs (LSAP).

By tightening financial conditions, central banks’ actions have a recessionary effect on economic activity, which is likely to weigh on growth and the stability of the financial markets that they have nevertheless supported through unconventional intervention tools.

Faced with the dilemma of having to fight for price stability while preserving economic activity and the financial sphere, central banks may choose to take minimal and delayed action. The risk would then be to see monetary conditions tighten insufficiently to vigorously combat rising prices, even as growth slows as a result of inflation and the withdrawal of monetary support.

Faced with this risk of stagflation, central banks are now more than ever forced to walk a tightrope. By normalizing their monetary policy « gradually » – in other words, marginally and cautiously (with key rates remaining well below inflation) – central bankers are seeking to avoid contradicting their mandate to fight for price stability without compromising economic growth and financial stability.