Paying a heavy price for central bank money creation

Much of the damage to bond and stock prices that we expected this year has been done. Markets are quickly adjusting to a new world of higher inflation in most advanced countries. They get used to the need to raise interest rates to fight price increases by slowing economies.

The markets were governed by the major central banks. Their study was crucial in projecting the future of economies and financial assets.

Asian markets were led by China and Japan, which managed inflation well, keeping it around 2.5%, despite their exposure to sharp increases in energy and food prices. Both also exercised reasonable control over their money supply and credit during the Covid shutdowns, with the People’s Bank of China maintaining its monetary target.

By contrast, major Western central banks – the Federal Reserve, European Central Bank and Bank of England – have failed to target or preoccupy money and credit, while actively promoting major expansion to offset the impact. general business supply chain blockages and disruptions. Each of them continued to push money creation into the recovery and ended up with double-digit inflation.

The Fed has given its economy the biggest boost and decided from the second quarter of this year to end all money creation, shrink its bloated balance sheet and aggressively raise interest rates from lows ultra low to show its determination to eradicate inflation. This led to a strong sell-off in bonds and many stocks, especially the growth hits of the long bull market.

The Bank of England was the first to put an end to monetary creation, stopping it last December. It is now trying to balance the need for higher rates to fight inflation against the risk of being so tough that it will cause a recession next year, choosing on Thursday to raise its main interest rate from 0, 5 percentage points.

However, the central bank with by far the biggest headaches is the ECB.

I kept the FT fund out of continental equities for a variety of reasons other than a small indirect exposure by holding the global index. The EU economy is suffering from an energy shortage, aggravated by Russia’s violent invasion of Ukraine and the need to withdraw Russian energy from Europe’s supply sources.

It has been damaged more directly by war and sanctions than the United States. On climate change, it has embarked on a vigorous path to net zero, which means shutting down or adapting many of its more traditional industries.

The Eurozone is still divided between surplus countries generating more euros through trade and economic success, and deficit countries running out of foreign currency and needing to borrow more. The original euro scheme had strong Germanic elements. Each member state had to control its own budget deficit and was responsible for its own borrowing. The central bank is not allowed to help member states finance excessive deficits. Deficit countries had to cut spending or raise taxes.

Today, many are those who wish to relax these strict rules. The need to maintain public deficits at 3% and public debt at 60% of GDP has been suspended. Surpluses from Germany and a few others are deposited with the ECB, which lends them to 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 zone. It’s fancy talk to try to keep borrowing rates lower for long-term and short-term loans at similar interest rates across member states.

The ECB sets the same short-term interest rate for the whole area, but it does not set the rates at which individuals and businesses can borrow from commercial banks in different countries and it cannot set the rates that states have to pay to cover their own bills by borrowing for longer periods.

She worries that Italy’s cost of borrowing is much higher than Germany’s. He wants to prevent the heavily indebted Italian state from having to pay too much for new loans and ending up in financial difficulties with its large interest bills.

In the two decades that Italy has been in the euro, it has not been able to reduce its public debt and it remains well above the required figure. The EU is now trying to help Italy by sending a large part of the central EU recovery funds to reduce the need for Italy itself to borrow. These funds are collected in the form of EU debt.

The ECB continued to create money and buy bonds until the end of June, when it ended its bond buying programs. There are now five countries in the zone with inflation above 10%.

However, he is worried about the current sluggishness of many national economies and wants to be able to buy the bonds of countries plagued by deficits to prevent their rates from rising too high. This is likely to prolong political confusion as it seeks to accomplish the nearly impossible task of preventing recession, stopping inflation and keeping bond rates together at the same time.

I continue to look for ways to get a better return on the substantial cash the fund has been managing, now that markets are more acknowledging the strains ahead.

Sir John Redwood is Charles Stanley’s chief global strategist. The FT fund is a fictional portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global equity markets while reducing investment costs. [email protected]

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