[US][EU][Japan]High inflation, weak economy! US, Europe and Japan in monetary policy dilemma →
Economic Daily
On June 15, local time, the Federal Reserve announced to raise the target range of the federal funds rate by 75 basis points; the European Central Bank held a special meeting to discuss bond market movements; Japan's 10-year government bond futures prices hit 9 years and 2 months since the largest one-day drop, the Bank of Japan announced that it will continue to implement unlimited buying of government bond futures "continuous price limit operation ". In the face of high inflation and a weak economy, the United States, Europe and Japan central banks have adjusted monetary policy, the effect of how, remains to be seen.
ECB rate hike on the line
The European Central Bank's monetary policy has turned a corner. The central bank announced a few days ago that it plans to raise key interest rates by 25 basis points at its July monetary policy meeting, and expects to raise rates again in September. The move means that the eurozone is following the pace of the US interest rate hike and the low interest rate policy that has lasted for 11 years is coming to an end.
The big shift in the ECB's interest rate policy has its deep background in the times. The impact of the Russia-Ukraine conflict on the global economy is expected to last for years, and the European economy has been hit hard. Due to heavy reliance on Russian oil and gas supplies, soaring energy prices have not only caused disruptions to European supply chains, but have further increased the threat of inflation. The eurozone economy is at risk of stagflation.
The ECB has been debating for a long time whether to raise interest rates or not. A rate hike was called for at the end of last year, but was stiffened by policymakers. Looking back at the course of the ECB's policy changes, the side effects of the current serious difficulties facing the European economy can also be reflected.
Since December last year, continued upward pressure on prices has forced the ECB to change its policy. Previously, the central bank's top brass has been stressing that inflation will be "temporary" and avoiding the issue of interest rate hikes. Some expert analysis suggests that inflation caused by prolonged low interest rates is eroding the purchasing power of Europeans. According to Eurostat data, inflation in the EU rose to 4.9% in November last year. At the time the ECB argued that, despite considerable uncertainty, there was good reason to believe that eurozone inflation would fall significantly this year and gradually fall back to the 2% target level in the medium term. This prognosis now appears to be incorrect.
The ECB believes that inflation in Europe is ostensibly driven by soaring energy prices, but that the root cause is a supply-side problem. This means that prices are rising because of supply chain disruptions, plant closures linked to the COVID19 outbreak and energy shortages caused by a significant reduction in Russian gas supplies to Europe. It is on this basis that the ECB has refused to take action to raise interest rates when not under the pressure of an imminent "wage price spiral", which would only stifle economic prosperity.
From the relevant data, the Eurozone Industrial Producer Price Index reached 37.2% in April, and the EU-wide Industrial Producer Price Index rose 37% year-on-year; the Eurozone Consumer Price Index hit a new high of 8.1% in May, reaching four times the central bank's inflation target. Obviously, the growing inflation in Europe can no longer be dismissed as an "unexpected rise". In response, ECB President Lagarde explained that the Russian-Ukrainian conflict continues to put pressure on the European and other regional economies and affects normal trade, leading to shortages in the supply of raw materials and making energy and commodity prices continue to rise. Some MEPs asked why the ECB's view had not changed, given that the economic environment had changed in the last six months.
It is for this reason that runaway energy prices have caused inflation to soar, prompting the ECB to reconsider its policy orientation from supporting economic recovery to curbing inflation, its "biggest challenge" at the moment. They have raised their inflation forecasts significantly to 6.8% in 2022 and 3.5% in 2023, while the key medium-term inflation forecast is for a fall to 2.1% in 2024. The ECB has three key interest rates, with the refinancing rate currently at zero, the marginal lending rate at 0.25% and the bank deposit rate at -0.5%. Of these, the deposit rate, which is typically the interest earned by commercial banks for cash held overnight at the ECB, has been negative since 2014. The roadmap set by Lagarde is to exit negative interest rates by the end of September.
The impact on markets of this determined policy U-turn by the ECB cannot be underestimated. Since the central bank announced its plan to raise interest rates, bond yields in the European market have soared, with the benchmark 10-year German bund yield reaching 1.7% at one point and the Italian 10-year bund yield breaching 4%, with spreads widening sharply. This has also raised the alarm of the financial management, and the ECB Interest Rate Management Committee held an emergency special meeting on June 15 specifically to discuss the recent unusual movements in the government bond market. Lagarde warned that the ECB would "not tolerate changes in financing conditions that go beyond the fundamentals and threaten the transmission of monetary policy". This means that the ECB may intervene at any time.
Why is the issue of bond spreads such a big concern? The 27 EU member states pay different prices for their respective public debt. Spreads are often seen as a sign of investors' relative confidence in different government bonds or in the ECB's commitment to back them. The wider the spread, the more difficult it is for highly indebted countries such as Italy or Greece to finance their debt and the more likely it is that another sovereign debt crisis will erupt. So the ECB is often under pressure from member states in the Eurozone and Lagarde has had to reassure the European Parliament that the ECB will ensure that its monetary policy is properly transmitted throughout the Eurozone.
The poor economic outlook highlights the difficult task Lagarde faces in curbing high inflation by raising interest rates without jeopardising the already faltering eurozone economy. The ECB is in a real dilemma, especially as the Federal Reserve has already taken more aggressive measures. The central bank has already lowered its economic growth forecast for the eurozone to 2.8% and 2.1% for this year and next, respectively, and believes that the impact of the Russian-Ukrainian conflict will continue to grow.
The weakness of the eurozone economy is a fact. According to OECD statistics, eurozone GDP growth stagnated at 0.3% in the first quarter of this year, and continued to weaken in the second quarter. Business confidence saw a record decline, with the German purchasing managers' index in particular falling to a 15-month low in April. Unemployment was also on the rise, with the eurozone's seasonally adjusted unemployment rate standing at 6.8% in April. The ECB monetary policy could tighten more rapidly than expected in the event of a reduction in gas supplies or strong wage growth. In the face of a tight energy situation and raging inflation, an ECB rate hike is already on the cards.
Aggressive interest rate hikes in the US are not a good idea
The US is in the midst of the worst inflation since the early 1980s, which means that the average American is experiencing a rapid rise in the cost of living. Today, the US is struggling to come to grips with inflation, and the risks associated with managing inflation are increasing.
Supply and demand are pushing up inflation
According to macroeconomic theory, inflation is mainly influenced by three factors: the unemployment rate gap under aggregate demand regulation, supply shocks and expected inflation rate.
On the demand side, aggressive fiscal and monetary policies in the US have pushed down the US unemployment rate from a high of 14.7% at the time of the COVID19 outbreak in April 2020 to 3.6% in the last three months, significantly lower than the long-term natural unemployment rate of around 5% in the US. A lower unemployment rate than the natural rate means that the level of output is higher than the potential level of output and that there are signs of overheating in the short term, generating what is known as "demand-pull inflation".
Since the outbreak of the epidemic in the US, two administrations have been extremely expansionary in their fiscal spending. The Trump administration passed a US$2.5 trillion stimulus bill and aid bill in March and April 2020, and the Biden administration passed a US$1.9 trillion epidemic relief bill and a US$1.2 trillion infrastructure investment and jobs bill in March and November 2021 respectively. The aggressive fiscal stimulus pushed the size of the US national debt to over US$30 trillion and the government's debt ratio to over 130%, more than twice the international alert level of 60%. The US fiscal deficit rates for fiscal years 2020 and 2021 are 14.9% and 16.7% respectively, about five times the international warning line of 3%.
US monetary policy is not far behind. As early as March 2020, the Fed emptied almost all the ammunition in its conventional monetary policy toolbox, lowering the target range for the US federal funds rate to between 0% and 0.25% and initiating a new round of quantitative easing by lowering the statutory reserve requirement ratio to 0% and reducing the central bank's Tier 1 credit rate to commercial banks to 0.25%. At the same time, the Fed also reverted to instruments such as the IMF lending facility and commercial paper financing facility used during the sub-prime crisis to provide liquidity support to the shadow banking system. The bottomless flood of dollar liquidity has exceeded the monetary needs of the real economy and the flood storage capacity of the capital markets, ultimately becoming the most important driver of the current severe inflation.
On the supply side, the unilateral economic and trade frictions between the US and China, the Russia-Ukraine conflict and the epidemic have together pushed up the cost of supply for US companies, resulting in so-called "cost-push inflation".
Since March 2018, the Trump administration has unilaterally launched several rounds of economic and trade frictions with China, imposing tariffs on more than US$500 billion of Chinese exports to the U.S. In January 2020, after the first phase of the U.S.-China economic and trade agreement, the U.S. side retained special tariffs of 25% on US$250 billion of goods and 7.5% on approximately US$120 billion of goods. China has long been the number one source of imports to the US and provides a large number of good quality and inexpensive consumer goods to the US population. The tariffs imposed by the US on China are mainly borne by American companies and passed on to consumers through price increases.
A number of US sanctions against Chinese companies have also reduced production and supply chain efficiency in many industries, driving up the price of products such as chips. The outbreak of the Russia-Ukraine conflict has reduced the scale and efficiency of exports from Russia, Ukraine and Belarus, which are important global suppliers of energy, agricultural products and minerals, thus pushing up the prices of global commodities. Higher prices for energy, agricultural products and minerals, which are important inputs to the production of companies in various countries, pushed up the prices of downstream consumer goods. The epidemic also caused severe underemployment in various industries in the US for a time, making it difficult to supply various commodities, which in turn also led to increasing prices for many commodities. These negative supply shocks, which directly raised business costs, left the US facing inflation and suffering from sluggish economic growth at the same time.
In terms of managing expected inflation, the Federal Reserve and the various departments of the US government have been careful to "take care" of the markets and the public since April 2020, when this round of inflation began. Both the Fed Chairman and the US Treasury Secretary have said that inflation is "temporary" in an effort to get people to lower their inflation expectations and to reduce the real rate of inflation through rational expectations, which have not been successful in managing inflation expectations as the US Consumer Price Index rose 8.6% year-on-year in May. Officials have openly admitted to misjudging inflation, public confidence in the US to reduce inflation is waning, and the formation and self-fulfilment of high inflation expectations will continue to reinforce realistic levels of inflation. This will also erode the credibility of US inflation management and make anti-inflationary policies much less effective in the future.
The dilemma of what to do
In the face of severe inflation, the US government has tried to keep inflation down from both the demand side and the supply side, but the policy has not been as effective as it could have been.
On the demand side, the most powerful weapon to tackle inflation is undoubtedly the monetary policy of moving into the path of interest rate hikes and taperings, which started in November 2021 with a reduction in the size of asset purchases and in March 2022 with a 25 basis point rate hike to start the rate hike process. The Fed's monetary tightening policy is faced with a trade-off between price stability and economic recovery, and a dilemma. In the face of higher-than-expected inflation, monetary tightening must be applied, which may stabilize prices, but at the cost of lower output, increased unemployment and a plunge in the stock market.
In the first quarter of 2022, the equivalent annual rate of adjusted GDP in the US has already declined by 1.5%, and the US Dow Jones has fallen by 15% and the Nasdaq by 30% during the year. The Federal Reserve still hopes to strike a balance between managing inflation and firming up market confidence and will continue to implement multiple interest rate hikes with stable expectations. However, if multiple rate hikes fail to keep inflation down as expected, there is a risk that expectations management will fail completely, which may ultimately result in a hard landing for the US economy.
On the supply side, the US government has been making frequent statements and moves to lower the cost of production for businesses through multiple channels in order to reduce inflation levels.
For one, US President Joe Biden, Treasury Secretary Yellen and Commerce Secretary Raimondo have publicly stated on several occasions that they are inclined to relax some of the tariffs imposed on China under Trump. This move is undoubtedly intended to help curb high inflation in the US by lowering the prices of goods imported from China, but unfortunately it has been slow to do so. The possible reason for this is the fear of the Republican Party taking issue with this topic to influence the outcome of the Democratic mid-term elections.
Secondly, Biden is preparing to visit Saudi Arabia to seek increased crude oil supplies from the Gulf countries to calm oil prices and reduce soaring domestic fuel prices in the US. However, the U.S. government's Middle East policy in recent years and the contradictions with Saudi Arabia are destined to make Biden's trip to Saudi Arabia not easy.
Thirdly, the United States has liberalised its preventive measures in spite of the pending epidemic, hoping to increase the supply of various commodities by resuming full-scale work and production. However, the future development of the new pneumonia epidemic is still full of uncertainty, and monkey pox cases continue to appear, the public health crisis on the U.S. commodity supply and the impact of inflation in the short term fear of complete elimination.
Potential risks to be guarded against
The governance of hyperinflation in the US could have a significant impact on the global economy and finance through a number of channels.
First, the tightening of US monetary policy could bring about a new economic recession. A repeat of the 1982-1983 economic crisis brought about by then Federal Reserve Chairman Paul Volcker's management of inflation in the early 1980s may be on the horizon. Another recession in the US, the world's largest importer of goods, would have a huge negative impact on exports and production worldwide.
Secondly, the return of the global US dollar due to a rise in US interest rates would cause a plunge in asset prices in the capital markets and a sharp depreciation of national currencies against the US dollar in the foreign exchange markets. This sign is now very obvious, and if countries do not cooperate prudently to deal with it, I am afraid that the national wealth accumulated over the years will go down the drain.
Third, the United States will politically pressure other countries to make concessions in order to relieve its own inflationary pressures, and may even not rule out creating geopolitical crises or even military action to divert domestic political and economic pressures when the inflation problem is difficult to resolve. All the more reason for countries to be vigilant and prepare for a rainy day.
Japan struggles to curb government bond yields
On 15 June, the Japanese government bond futures market was in disarray, with 10-year bond futures prices plunging by more than 2 yen from the previous day, the biggest one-day drop in nine years and two months, forcing the Osaka Exchange to start the meltdown mechanism twice. The Bank of Japan announced that it will continue to implement unlimited buying of government bond futures "continuous limit operation" and hold a two-day meeting from the 16th to discuss the next step in monetary policy.
The Japanese media believes that the collapse of the Japanese government bond futures market is a manifestation of the intensification of the "war of attrition" between overseas investors and the Bank of Japan against the backdrop of global inflation and the Fed's interest rate hike expectations.
Analysis that the current global inflation intensified, the recent European Central Bank plans to raise interest rates, the Federal Reserve rate hike action frequently, overseas investors believe that the yen depreciation superimposed on Europe and the United States "hawkish" background, the Bank of Japan is difficult to bear the pressure, will follow the United States and Europe to modify the current quantitative easing policy, and thus the sale of government bonds.
For this reason, the Bank of Japan "strict defense", difficult to deal with. According to Japanese media reports, on June 13, the yield of Japan's 10-year government bonds had broken through the yield curve control (YCC) set by the Bank of Japan, once reaching 0.255%. On June 15, the Bank of Japan took measures to expand the range of limit operations to strongly respond to the selling behavior of overseas investors and announced the purchase of 2.45 trillion yen of government bonds.
Analysts believe that the increasing technical difficulties in curbing the rise in long-term government bond yields, coupled with rising domestic criticism of this policy leading to an accelerated depreciation of the yen, may push the BoJ to revise its monetary policy. Technically, the BoJ's quantitative easing policy objectives are not limited to controlling the yield curve, but also include increasing the effectiveness of the policy by intervening strongly in the market and reducing market functioning, which has had the side effects of disruptions in the government bond market and depreciation of the yen. While monetary policy should be tightened when the yen depreciates and prices rise, further easing is necessary to maintain long-term government bond yields, proving that Japan's current yield curve control is inherently structurally flawed and an easy target for concentrated attacks by overseas investors.
From a domestic perspective, the Bank of Japan's policy is "contrary" to that of Europe and the United States, and the continuation of accommodative policy to control interest rates will further widen the interest rate differential between the country and overseas, continuing to create space for the yen to depreciate. The devaluation of the currency has already led to a sharp rise in the prices of imported goods, mainly energy and food, in Japan, reducing the disposable income of the people and increasing the pressure of living. The Japanese media believe that this issue will be one of the main points of contention in the July Senate elections. Japan's Chief Cabinet Secretary Matsuo Hiromichi expressed concern about the yen's rapid depreciation at a press conference on the 15th, saying he "hopes the Bank of Japan will cooperate with the government and take the necessary measures as appropriate".
There are also views that, from the Bank of Japan's current firm actions and statements, due to the impact of external factors in the short term to adjust policy is less likely, even if the adjustment policy, the effect is limited. The Bank of Japan since the division of the chief economist said, "even if the Bank of Japan revised policy, interest rate differential will not be significantly reduced in the short term, the yen will not change the tone of depreciation. Price increases due to supply policies will continue. If faced with a worldwide economic slowdown, continued quantitative easing is the best policy".