Australian Economy

The world’s central banks are tightening monetary policy ‘in sync’, and we’re entering uncharted waters

Throughout history, central banks have often moved in similar directions.

But the current sharpness and near-uniform global tightening is arguably unprecedented in recent decades.

US rises offset RBA increases

The simultaneous rate rises are a factor in the Australian dollar remaining relatively low at about US70¢, despite local interest rates increasing and a record terms of trade (export prices relative to import prices).

RBA rate increases are being offset by larger US rate rises, limiting the capital flows into Australia chasing interest rate yields.

For a commodity-exporting, trade-exposed economy, the exchange rate is usually one of the primary channels for monetary policy to transmit through the economy.

But the relatively weak Aussie dollar means higher imported inflation and more foreign demand for our goods – contributing to domestic price pressures.

Hence, the RBA can’t fall too far behind other central banks in lifting rates.

JPMorgan’s economists calculate that developed market central banks have increased policy rates almost 2 percentage points from the 2021 low on a GDP-weighted average measure, and are poised to raise rates higher in coming months.

Emerging markets – excluding China, Russia and Turkey – have lifted by an average of 3.5 percentage points.

Not only are short-term interest rates rising, but central banks are also embarking on so-called quantitative tightening by allowing securities to passively run off their balance sheets or actively selling bonds.

The world has not experienced a material global quantitative tightening before. Previously, when the Fed temporarily shrank its portfolio of securities in 2017 and 2018, Europe and Japan were growing their balance sheets.

Developed market central bank balance sheets peaked at almost $US30 trillion from their purchases of bonds and other securities during the pandemic. JPMorgan economist Ben Jarman says the stock of global central bank balance sheets is only just now cresting and will gradually fall, while the flow of new bond purchases is declining sharply.

Uncertainty abounds

The size and acuteness of tightening in concert is an extra source of risk and uncertainty for central bankers, investors, businesses and households around the world.

Nobody knows how the simultaneous rate rises will shake out, particularly for highly indebted emerging market economies which face capital outflows and exchange rate depreciations as the US Fed lifts interest rates.

Usually, central banks have time to pause to assess the impact of initial rate rises, domestically and internationally, in the knowledge that monetary policy usually takes about 12 to 18 months to have its maximum impact. But high inflation means they have lost that waiting option.

For financial markets, synchronicity has been a risk brewing for a couple of years.

One experienced international bond trader says the “pandemic has resulted in countries having the same business cycle and coming out of recession at the same time.

“All with big government debt funding needs. All with cost pressures. All with expensive risk assets and large household debt. And all on the upswing at the same time.”

He contrasts it to past downturns and recoveries when there was more variance in economies and markets to offset the ups and downs in different countries.

For example, during the 1997-98 Asian financial crisis, other developed economies generally performed well.

During the 2008 GFC that drove the United States and Europe into deep recessions and market turbulence, Asia hung in there and a stimulus-fuelled China pulled through strongly – pumping up demand for Australia’s iron ore and coal.

“This time it’s a highly correlated recovery,” the observer says. “Will every central bank get it right? I doubt it. And they want a bit of inflation to help with government debt repayments.”

It’s not surprising that central banks are moving in lockstep.

The pandemic was a global shock, with similar health and economic responses, including lockdowns and massive stimulus payments. Policymakers underestimated the huge power of fiscal stimulus and didn’t foresee the supply constraints.

There is a very narrow path for central banks to contain inflation without doing too much damage to employment.

Much of the inflation was initially due to supply-side shocks, which are lingering longer than expected, including transport and logistics interruptions stemming from China’s restrictions, the energy price spike and labour shortages.

The US and Britain lost millions of workers, perhaps due to early retirements or concerns about catching the virus.

Australia missed two years of immigration, leaving a smaller pool of available workers.

Let’s hope the synchronised, trans-Atlantic economic downturn doesn’t wash up in Australia.

Hence, the level of supply in the economy will be at a permanently lower level than its pre-pandemic trajectory, even if the growth in labour and supply chain capacity returns to more normal rates.

Hence, central banks can’t just “look through” all the supply shocks. There is less supply to accommodate stimulus-fuelled demand, setting a new equilibrium that interest rates must respond to.

Supply will be permanently restricted compared with the pre-pandemic path, so central banks must tighten policy to cool overheating consumer demand.

Arguably, central banks could have moved sooner, but that wouldn’t have fixed the current bout of high inflation.

But an earlier tightening would have put interest rates closer to where they need to be, and made it easier to reduce inflation over the next few years.

Admittedly, it is now more difficult for central banks to manage inflation.

Central banks during the post-Cold War “great moderation” got somewhat lucky on achieving low and stable inflation, thanks to China’s industrialisation that pushed down the costs of manufacturing and added hundreds of millions of workers to the global labour pool, globalisation, free trade flows and the technology revolution.

Arguably, monetary policy received too much praise, when other significant factors expanded the economy’s supply capacity.

Now, central banks face the toxic combination of exploding demand and reduced supply, including onshoring of some critical manufacturing, the energy crunch, geopolitical tensions that undermine trade and technology sharing, and labour force dropouts.

Shallow recessions in the US and Europe are the baseline forecast of economists.

Let’s hope the synchronised, trans-Atlantic economic downturn doesn’t wash up in Australia.

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