Help, inflation is back !: When will the central banks step on the brakes?

The financial markets are twitching nervously. The firepower of corona packages worth billions is driving inflation. Do the Fed and the ECB have to scale back their ultra-loose monetary policy? Memories of the time after the financial crisis are awakened.

The specter of inflation has been awakened. For some, they already cause fear and horror. Memories of the 1970s are awakened. A lot of money was pumped into the real economy during the Corona crisis. The effect cannot be overlooked: All economic areas around the world are growing at the same time, which is unusual: According to the new OECD economic outlook published this week, the global economy will grow by 5.6 percent in 2020. As recently as December, 1.4 percentage points were assumed to be lower.

Most economists corrected their forecast for the USA upwards, by 3.3 percentage points to 6.5 percent. As a rule, only emerging countries such as China create such an increase in gross domestic product, but not the developed industrial nations. The USA will become the locomotive for the global economy. The economy of the G20 countries will grow by 6.2 percent and that of the euro zone by 3.9 percent in the same period.

A lesson from the Lehman crisis

The other side of the coin is the resulting rise in inflation. The US is not messing up, it is messing up to prop up the economy. Only the evening before, the US Congress waved a corona package worth almost two trillion dollars. Its size corresponds to almost ten percent of the annual US economic output. The money is supposed to boost the economy and relieve the burden on citizens. In the USA, some unemployed people have more money than they did before the pandemic, when they were still working. The question that many observers are now asking themselves is: can this inflation monster be tamed or will it go about its mischief in an uncontrolled manner? Should the alarm bells ring out at the central banks?

This is currently being hotly debated in the financial markets. The hopes for a rapid and sustained upswing are already directly reflected in the increased raw material prices. The prices for oil and copper have already increased significantly, assuming that demand will increase. In addition, oil companies and mining companies have scaled back their investments in the past few years and hardly any new deposits have been explored and developed. All of this drives up prices.

On the one hand, experts praise the determination with which governments proceed in the crisis. "The situation is much better than after the 2009 financial crisis," said OECD chief economist Laurence Boone this week. The governments reacted quickly with large stimulus packages and thus heeded the lessons from the mistakes of 2009. On the other hand, skeptical voices also warn that the money could run the economies hot.

"As if you ask for rain and get a monsoon"

The US Federal Reserve in particular could soon come under pressure. "If US President Joe Biden's rocket detonates, the US economy can overheat," says the head of the Kiel Institute for the World Economy, Gabriel Felbermayr: The massive economic program could not only trigger a boom in the US, but "also ensure price increases on the world markets".

IMF chief economist Olivier Blanchard believes the US government's aid package is clearly excessive. "It's a bit like asking for rain and getting a monsoon." In his view, the US could take more debt. "But just because of that you don't necessarily have to do it," he told the "Handelsblatt". The US government's stimulus package is "roughly three times what it would take to remedy the underutilization of the US economy." If the economy overheats, inflation rises and the Fed has to step in and slow down, the renowned economics professor added.

Has the time now come for the Fed or the ECB to at least consider getting out of their ultra-loose monetary policy and scaling back bond purchases? A process that the Anglo-Saxons call "tapering", some people may remember. Immediately, the monetary authorities do not seem to see any reason for this. So far they have asserted that they will tolerate higher inflation. The Fed explicitly does not want to correct its monetary policy. The US Federal Reserve Chairman Jerome Powell recently made it clear that the development is not "disordered" and therefore does not require any intervention.

Indeed, inflation is still subdued on both sides of the Atlantic, but that could change very soon. At 1.4 and 0.9 percent, respectively, inflation in both the US and the euro zone is still a long way from the central banks' target of around 2 percent, but it is rising steadily. Experts believe that at least short-term inflation rates of around 3 percent are quite possible.

Should interest rates soar well above the target of two percent, the pressure will grow – initially on the Fed and, in the future, also on the ECB. The trillions of dollars of savings accumulated during the crisis that are waiting to be spent could further fuel inflation, by the way.

Rise in returns doesn't just make investors nervous

The inflation scenario is already being played out on the bond markets. Yields have risen recently. The trend-setting government bonds from the USA and Germany were quoted as high as they were about a year ago. When their returns rise, they also drag up corporate interest costs. This has a negative effect on companies' margins and has a negative impact on economic development. Not a dream scenario in the crisis.

One explanation for the noticeably rapid rise in US yields is that the corona package, which is worth billions, also means that there are many bonds that the state has to issue to finance, i.e. sell. The more bonds come onto the market, the lower the prices – conversely, interest rates rise (at least normally). Which in turn is a sign of inflation, because interest is the price of money borrowed.

Powell has rightly withdrawn his wording, considering how the markets punished ex-Fed chairman Ben Bernanke in a similar situation after the financial crisis. He made a big mess of the markets by dropping – casually – in a 2013 hearing that the Fed could gradually cut back its asset purchases if the economic data persisted. The result was a stock market tremor that went down in history as the "Taper Tantrum". A kind of tantrum because investors feared that bond purchases would be cut back. Powell certainly didn't want to risk such a scenario.

But the question is: what will the Fed do if inflation actually surpasses the two percent target? Maybe even beyond the three percent? Can and will it still keep interest rates low? It is unclear whether the central banks will succeed in lowering interest rates at this level. Only a market test will show that. One possible scenario is that the markets would then bet against the central banks. But it is at least conceivable that the monetary authorities will reduce their ultra-expansionary monetary policy. Some investors expect an initial US interest rate hike as early as mid-2022 instead of towards the end of 2023, as the Fed has signaled so far.

"High inflation is eating up national debt"

The mountains of debt that have accumulated clearly speak against an exit from the ultra-loose monetary policy. Inflation "sprouts like asparagus in spring," says Robert Halver, head of capital market analysis at Baader Bank ntv. Only "high inflation eats up national debt".

The central bankers of the ECB raised their inflation expectations on Thursday. The monetary authorities increased the rate to 1.5 percent for this year. In December they had assumed an increase of only 1 percent. It is also clearly possible that the European rate of inflation will temporarily rise to 2 percent at the end of the year, said the euro guardians. Nevertheless, they signaled a clear willingness to continue pumping money into the economy. An undesirable further increase in yield is to be countered with increased bond purchases – the borrowing costs should remain low. That is why the pace of bond purchases is now increasing.

ECB boss Christine Lagarde justified the procedure through technical effects such as the end of the German VAT cut and the rising oil price. The rise in interest rates on the markets is "a risk", "comprehensive monetary policy easing" is required. The financial markets reacted immediately, yields fell. "The markets are happy that the ECB will do a little more in the next quarter. But it has provided little clarity about what it wants to do in the longer term," commented Konstantin Veit from asset manager Pimco at ntv. The inflation forecast suggests that the ECB is assuming that it will miss its target of two percent inflation by a wide margin over the next three years. An interest rate hike is "probably not to be expected before 2025".

The further market reaction will be exciting, commented LBBW chief economist Uwe Burkert on the ECB decision. It could well be that some players now want to test the determination of the ECB, so that a further increase in yields will be seen. "But in the end the central bank has more leverage because it has unlimited ammunition."