Thread by @farzamehsani

Central banks are in a tough position in their fight against inflation 🧵

Inflation is at levels not seen in advanced economies for decades

US: 8.6% (highest in 40 years)
Europe: 8.1% (hitting record high for 7th month in a row)

Reminder that US and Europe inflation targets are 2%

Other countries also experiencing high inflation across the board

These levels relate to the Consumer Price Index (CPI) which measures the price of a basket of goods and services like cereal and milk and which is a measure looked at by central banks (CBs). (Many think CPI is out of tune with real living expenses but let’s proceed nonetheless)

20-30 years ago CBs started their policies of inflation targeting (New Zealand was the first CB to do so in 1990, South Africa started in 2000, and the Fed started in between).

CBs have tools to target inflation:

1) Set interest rates (discount rate/repo rate used with banks)
2) Open market operations (buy/sell financial assets to influence interest rates in the market)
3) Reserve ratio requirements (for bank lending)
4) Forward guidance (for market)

From 2008 (global financial crisis) CBs like the Fed tried to stimulate the economy by moving interest rates effectively to zero (to make capital cheap) and pumping trillions into the economy by buying financial assets (aka “quantitative easing”).

Problem is a lot of this liquidity didn’t show up in CPI and just pushed up the price of financial assets instead of cereal and milk because how much more cereal and milk do institutions/people with financial assets actually need?

With war, sanctions, supply chain issues (eg lockdowns) and more, the supply side of the economy has been affected. Turns out Russia & Ukraine supply a lot of food and energy to the world. And when supply decreases, prices go up which has now shown up in CPI.

And since CBs keep an eye on CPI they are now trying to combat inflation with their tools. So interest rates are going up and open market operations are being wound up.

But since CB tools didn’t do much for CPI and pushed up financial assets a great deal, we’re now seeing a pullback in these same financial assets/markets but not much pullback in CPI.

And CBs are now worried. The Bank for International Settlements (the CB of CBs) just put out a report saying: “We may be reaching a tipping point, beyond which an inflationary psychology spreads and becomes entrenched. This would mean a major paradigm shift”

Paradigm shifts in reports just mean things will change significantly. IRL paradigm shifts mean real creative destruction (h/t Schumpeter). And creative destruction in money hasn’t been seen much in our lives. But monetary history is littered with such tales (not fairy tales tho)

What will it look like? How long will this process take? What role will crypto play? Tbh no one really knows. The truth (and the economy) is a lot more complex than what I’ve set out above. Only time will tell.