By most accounts, an air of self-congratulation hung over last weekend’s annual gathering of central bankers at Jackson Hole in Wyoming.
Miraculously, these lords of finance had pulled off the seemingly impossible by returning inflation broadly to target without inducing a recession. In the jargon, this is known as a soft landing, and it scarcely ever happens.
The normal pattern is one of boom and bust; the economy overheats, inflation takes off, belatedly the central bank acts to cool demand by raising interest rates, the therapy is overdone, the economy slows and then stalls, business activity contracts and unemployment rises.
Many learned economists predicted just such an outcome this time around. So indeed did the Bank of England. In November 2022 the Bank’s quarterly monetary policy report predicted the longest recession in living memory; GDP was expected to contract by 0.75pc in the second half of 2022 then continue falling throughout 2023 and the first half of this year.
In the event none of this happened, despite the fact that Bank Rate quickly rose to the levels assumed in those forecasts. A very mild and short-lived recession was quickly followed by a relatively strong rebound.
A similar trajectory was followed by the US economy, where like the Bank of England, the Federal Reserve initially dismissed the spike in inflation as “transitory” before belatedly slamming on the brakes when second round effects took hold.
So here we are, with the brakes duly applied but no sign of the recession you would have expected from such a severe and rapid monetary tightening. It did not require a steep rise in unemployment, it would seem, to douse the inflationary flames.
It may, of course, still be too early to declare victory; there is a sizeable school of thought that suggests recession remains very much on the cards – it’s just on a long fuse. The embarrassing admission that the official data has overstated US jobs creation by 880,000 suggests that things are not as buoyant as assumed.
Even so, financial markets remain sanguine. After the temper tantrum of a few weeks back, stock markets are again testing all-time highs, encouraged by dovish remarks at Jackson Hole from Jay Powell, the Fed chairman. The Fed will be cutting interest rates sharply from next month onwards, he implied. It seemed to be enough to calm nerves.
Still, it is more by luck than design that things haven’t turned out a good deal worse. There is not yet enough research on precisely why and how such outcomes were avoided, but here are a number of likely explanations.
First, the inflationary surge that prompted the steep rise in interest rates was very unusual in its causes. The preceding pandemic saw governments around the world effectively close large parts of their economies down with social distancing measures.
Demand was artificially suppressed, so that when the measures were lifted, it came surging back to preceding levels into an economy where supply had been badly damaged by prolonged lockdown.
It was hard to spend on services during the pandemic, which had the effect of unduly skewing what demand there was towards goods, creating bottlenecks in supply and raising prices accordingly. Services followed suit as soon as they were allowed to open again. To compound it all, Putin’s invasion of Ukraine caused fuel prices to spiral upwards, further adding to input costs.
Once these factors had readjusted back to normal, much of the inflation began to disappear.
Second, inability to spend as usual during the pandemic led to substantial savings surpluses which cushioned consumers from the effects of rising interest rates on mortgages and other borrowing costs.
Moreover, wages quickly caught up with inflation, with the result that disposable income was largely protected from rising prices.
And third, relatively high levels of immigration – both in the US and the UK – and the fiscal stimulus of Bidenomics in the States, helped keep GDP growing, notwithstanding the severity of the monetary squeeze.
The other thing that tends to happen with rising interest rates is that it catches many parts of the financial system by surprise, sparking in hidden areas of the economy a chain reaction of insolvencies and losses which damage broader financial and business confidence.
Central banks have been busy ensuring this doesn’t happen.
At the first sign of grapeshot they are on it, underwriting depositors against loss as happened with the collapse of Silicon Valley Bank and other small US regional banks, and in the UK with the liability-driven investment crisis, when the Bank of England was forced to step in to prevent a fire sale by pension funds of UK government bonds.
In Switzerland regulators quickly organised a rescue when Credit Suisse looked as if it was going to the wall.
This is all very well, and no doubt helps protect the wider economy from the destruction of financial markets.
But interventions of this type also have the effect of suppressing an essential part of the business cycle, which is to purge the system of rotten apples so as to allow for more productive allocation of capital.
By the bye, it also adds to moral hazard. Pretty soon, investors and financiers start to believe they are guaranteed against almost any loss by central bank intervention, and you end up with something like the “Greenspan put”, named after the former Fed chairman Alan Greenspan, where finance positively expects to be bailed out.
This was also the lesson drawn by financial markets from the “dash for cash” in the early stages of the pandemic, when flight to safety prompted the widespread dumping of government bonds and money market funds in favour of pure cash.
Once again, central banks stepped in to calm the waters by buying debt and otherwise providing oceans of liquidity. It stemmed the crisis, but it also encouraged finance to believe there would always be a backstop. Leverage and other high risk forms of lending have been on rocket boosters ever since.
As Raghuram Rajan, former governor of the Reserve Bank of India, put it in a recent article: “Economic stabilisation may, paradoxically, raise the chances of financial instability”.
By constantly hosing down the flames, central banks are very likely incubating the next mega-crisis.
Not that there is any reason to believe this is imminent. A bit like the next eruption of Vesuvius, no-one can tell you when it might happen.
Worryingly, the international resolve to do much about it when it does, may be lacking next time around.
Not only has enthusiasm for the global financial reform agenda instigated after the financial crisis of 2008-10 waned, but it is also hard to imagine the world coming together as it did back then with a coordinated plan of action when the next big one hits.
Today’s world is a much-changed place, with rising geopolitical division and tension and many nations already too fiscally stretched to provide countervailing stimulus. Central bankers should enjoy their soft landing while they can; it won’t last.
Central bankers should enjoy their soft landing while they can – it won’t last
By hosing down the flames, central banks are very likely incubating the next mega-crisis