FRANKFURT – Central banks and governments are on a collision course.
For 15 years, central bankers around the world worked hand-in-hand with elected leaders to boost economic growth and inflation.
Now, with inflation at multi-decade highs, technocratic central bankers are driving up the cost of servicing mortgages and other debt, just as many governments are spending heavily to absorb higher energy costs caused by the war in Ukraine and meet new commitments. including defense.
If central banks continue to raise interest rates, they will increase the cost of servicing debt and could put millions of people out of work. If they blink and keep interest rates low, investors, businesses and households could doubt their willingness to fight high prices, potentially ushering in a new era of high inflation.
So who will come out on top – governments or central banks? Central banks have universally promised to restore low inflation at all costs; However, some economists are seeing some signs that they are becoming more focused on government needs.
The Bank of England Governor Andrew Bailey’s pledge to buy more government bonds was at odds with earlier plans to reduce bond holdings.
Photo: Andy Rain/Shutterstock
On Friday September 23, the UK government unveiled big energy subsidies and tax cuts without saying how they would be paid for. Investors, fearing the plan would fuel already high inflation, pushed bond yields higher and sterling lower. Some expected Bank of England Governor Andrew Bailey to respond with an immediate rate hike rather than at the next scheduled November 3 meeting. He did not do it; Instead, on September 26, he said the bank would make a decision on interest rates in November. Two days later, amid a rise in bond yields, the bank pledged to buy more government bonds, an announcement that ran counter to previously announced plans to reduce bond holdings.
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Bank of England officials said the debt purchases were aimed at countering a bond market dysfunction that is threatening financial stability, rather than to help the government borrow. Huw Pill, the bank’s chief economist, said it would likely respond to the government’s spending plans with “a significant and necessary monetary policy response” at its next policy meeting in early November.
Still, “the decision makes it seem like the BOE is both reversing policy and poised to fund a rise in public debt,” said Katharine Neiss, a former Bank of England economist who is now chief economist for Europe at PGIM Festes Income. “These optics raise concerns about central bank independence, weigh on sterling and on inflation.”
In June, eurozone financial markets faltered as the European Central Bank prepared to raise interest rates. ECB officials hastily called an emergency meeting and unveiled a new program to purchase the debt of embattled euro-zone governments like Italy’s – even as it moved to raise the cost of short-term borrowing to fight inflation that hit September 10 % achieved, a record.
“I don’t recall the ECB convening an emergency meeting to address abnormally high inflation rates. You can see where the ECB’s priorities lie,” said Jörg Krämer, chief economist at Commerzbank in Frankfurt.
Federal Reserve Chair Jerome Powell said in December the timing of his reappointment would not affect when the central bank decides to hike rates.
Photo: Drew Angerer/Getty Images
The Federal Reserve only ended its Treasury purchases in March, two years after the pandemic began. Over the past year, it has continued to buy up mortgage debt as part of a real estate boom. With hindsight, some economists say the Fed should have started raising interest rates last year, at a time when President Biden was considering whether to reappoint Jerome Powell as chairman. Mr Powell said last December the reappointment will not affect when the Fed decides to hike rates. The timing, he said, was determined by data on wages and inflation.
Central banks around the world have varying degrees of legal independence. In theory, Congress can take power back from the Federal Reserve and the UK government can direct its central bank on monetary policy. However, from the 1990s governments moved to grant them de facto independence by giving them an inflation target. After the global financial crisis of 2008, that independence wasn’t really tested, as low inflation and weak demand meant central banks and governments agreed they wanted lower interest rates and more expansionary fiscal policies to support spending .
Inflation is now well above target in almost all advanced economies, and central banks are raising interest rates in response, moves at odds with many governments that continue to borrow heavily.
“While central banks have a mandate to fight inflation, in practice they find it difficult to do so at any cost,” said Stefan Gerlach, former deputy governor of Ireland’s central bank. “They might worry about the government’s ability to pay interest on the national debt when interest rates are too high and the ability of households to service their mortgages.”
Another problem: Central banks hold trillions of dollars in bonds and other assets acquired during recent crises, including the pandemic, and paid for by issuing currency to the public and reserves to commercial banks. When interest rates were around zero, that led to large profits, which they remitted to governments. With interest rates now rising and bond prices falling, they may report losses instead. “If you have profits, you can protect your independence. Losses weaken central bank position,” said Panicos Demetriades, former ECB rate setter and central bank governor of Cyprus.
Central bank defenders argue that consistent with their responsibility for financial stability, they can still take targeted action without jeopardizing their independence. For example, the Bank of England and the European Central Bank could offset the stimulus effect of targeted bond purchases by selling other assets, open market operations or by raising short-term interest rates more than planned. Bond investors have not built in higher inflation expectations in response to the BoE’s recent actions.
Yet central bankers are caught between two fires. Even without explicitly considering governments’ needs, the Bank of England must weigh whether to aggressively raise interest rates on November 3rd, which should help stabilize the pound but leave homeowners, businesses and other borrowers to blame for government action to punish effectively. If not, the pound could fall and push up inflation.
“This clash will show that central bank independence is much more limited than we thought. I would be surprised if inflation doesn’t stay higher,” said Mr Demetriades.
write to Tom Fairless at [email protected]
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