Thread by @KellerZoe

We must not murder the recovery: inflation will soon take care of itself.
✍️🏼 AEP
telegraph.co.uk/business/2022/…

Central bankers were too late in 2021 but the worst they could make in 2022 is to swing suddenly from loose money to tight money, sending Western economies clattering into recession. You do not correct one policy error by committing the opposite policy error.

Many voices call for drastic rises in interest rates. Be careful: the monetarists themselves are not making such an argument. They are the new doves. Monetary policy effects require 12-18 months. It is too late to do anything useful about the inflation shock of recent months.

“Now is not the time for central banks to be pivoting hard. Global manufacturing (PMIs) is rolling over and new orders are at an 18-month low. The stock building cycle is about to turn down violently,” said Simon Ward from Janus Henderson.

Ward said the “monetarist” view is that central banks should try to stabilise broad money growth (M4 in the UK) at a steady pace over time. The US Fed and the Bank of England “trashed this principle in 2020-21, pursuing policies that caused money growth to explode”.

Today it is water under the bridge. Britain is not on the cusp of a self-feeding process of inflation or an accelerating wage-price spiral akin to the early 1970s – though the argument is more plausible in the US.

Ward adds: “I am very sceptical that the BoE will keep raising rates or get around to selling assets”. Central banks carried on with bond purchases à outrance last year even though the output gap was closing and fiscal policy was the most expansionary ever seen in peace-time.

It will be uncomfortable for the BoE since it paid scant heed to its former chief economist, Andy Haldane, who warned that a “coiled spring” recovery was coming, with inflation to match. But now that debate is irrelevant: the 2021 surge in the money supply has long since peaked.

“I am worried money growth will fall too far as central banks start selling assets,” said prof Tim Congdon, éminence grise of British monetarists. “If they let the money supply contract, we’re going to have a thumping bear market and a gruesome recession in 2023.”

The goal should be a gentle rise of broad money within a band of 2-5% a year. “If we go suddenly from 25% growth to 0%, we’re going to lurch from boom to bust,” he said.

Prof Congdon (Institute of International Monetary Research) made the opposite critique at earlier stages of the pandemic, firing off serial anathemas at BoE, and accusing central banks of monetary vandalism. His warnings turned out to be much closer to the mark than theirs.

He was scathing about pseudo-orthodox claims that supply chain problems lie at the root of soaring prices. You cannot explain the 20% rise in the price of existing US houses over the last year on the lack of semiconductor chips or delays in container shipping from China.

Monetary policy works with a lag – typically 12-18 months – so decisions today set our fate next year. Today’s inflation is the legacy of QE asset purchases in 2020. The headline CPI rate will peak above 7% in April for mechanical reasons. It does not tell us much.

Prof Congdon said the growth rate of M4 in the UK has already slowed to appropriate levels and should not be restrained further, but such overkill is implied by the BoE’s hawkish plan for quantitative tightening (QT).

It will cease to reinvest maturing bonds and will begin active sales of its asset portfolio this year. “They need to be careful. Commercial banks in the UK are still facing regulatory hurdles and don’t want to lend, so there could be a fall in money balances in late 2022”.

The BoE’s new chief economist, Huw Pill, seems to agree. He hinted yesterday that markets are pricing in too many rate rises this year, and said inflation might settle down gradually without scorched-earth measures.

The bubble is greater in the US and so is the inflationary impulse. Even so, there will be trouble if the Fed raises rates 7 times this year and launches QT in tooth and claw, as Bank of America expects. My presumption is that a liquidity seizure will force the Fed to back off.

Dario Perkins (@darioperkins), who helped design the BoE’s modern structure, said the monetary policy committee has been spooked by inflation and wants to show that it is not a fiscal captive of the Treasury.

“They have lost confidence in their story that inflation is ‘transitory’. Deep in their psychology is the fear that this really could be like the 1970s, and now they are overcompensating for all the terrible things they have been accused of,” he said.

“They need to tone down this hawkishness: there is no good argument for tightening further. The sense that the global economy is overheating could evaporate within 6 months. Then everybody will be talking about a growth scare” said Mr Perkins (Head of global macro at TS Lombard).

Contrary to general belief, energy spikes do not automatically cause a self-feeding process of inflation. “Every oil shock since the 1970s has been deflationary,” he said.

The definitive work is Systematic Monetary Policy and the Effects of Oil Price Shocks, written by Ben Bernanke in 1997, before he went on to greater things. It concluded that energy spikes lead to slumps because central banks mistake them for inflation, and tighten too hard.

The ECB learned this the hard way. It panicked in mid-2008 when oil hit $148 (£109) a barrel, raising rates even though Italy and Germany were in a recession. That was the final straw for a global financial system already crumbling.

This time the ECB is being careful. Lagarde told Euro MPs this week that soaring energy costs may indeed be deflationary. Yes, rising energy costs can lead to 2nd-round effects on wages.

But, “on the other hand, they can have a negative impact on incomes and earnings, reducing economic activity and dampening inflation. In the past, the euro area has been particularly vulnerable to the second channel,” she said. Bingo, Madame.

Central banks have an invidious task. They can certainly be forgiven for errors made while flying blind during Covid. But they will not be forgiven if they murder this recovery a full two or three years before the end of its natural cycle.