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The world looked on in horror last week as the UK’s market collapse prompted the Bank of England to reverse its plans for quantitative tightening with a spectacular intervention in the gilt market — “on whatever scale is necessary†— to save the nation’s pensions system.
So far, this appears to be a uniquely British debacle. But what if the UK isn’t an outlier and, by dint of Chancellor of the Exchequer Kwasi Kwarteng’s ill-fated dash for growth, is instead merely the first to reflect a new global reality? Let’s face it: The days of inflation-free monetary stimulus that globalization facilitated — and serial crises subsequently deepened — are over. This will have all sorts of unintended consequences for asset prices in general and bond yields in particular, as we’re starting to see. Any future equity market collapse won’t be magicked away as easily by the central banks. Kiss goodbye to the Greenspan-Bernanke-Draghi put, where interest rates were slashed whenever asset markets wobbled.
Central banks, in public at least, are still clinging to the idea that inflation is transitory and that, if we are prepared to endure recession, it will eventually revert to their mandated target of around 2%.
Back in 1980, then-Federal Reserve Chair Paul Volcker famously triggered a global recession by hiking the Fed funds rate to 20% to squeeze inflation out of the system. Conventional wisdom has it that this heralded nearly four decades of low inflation growth: the so-called Great Moderation.
But that’s not really what happened in the 1980s and into the 1990s. By the time we emerged from the Volcker recession, China had begun the process of investment, development and steadily opening to trade. That made the world economy a very different place. Thanks to growing international trade, rather than monetary policy, inflation was capped and extreme poverty started to plummet.
Compelling evidence for the inefficacy of monetary policy to guide inflation comes from the failure of ever-more extreme central bank easing to meaningfully lift consumer prices during the early 21st century. Such historic monetary accommodation, though, did lead precisely to the financial fragility that triggered both the 2008 global financial crisis and the gilt market meltdown.
But since 2008, world trade has fallen significantly as a proportion of global gross domestic product. Propelled by financial crises and Trump’s trade war, it has dropped from a peak of 61% in 2008 to just 52% in 2020, its lowest level since 2003. Since then, of course we’ve had a pandemic, a shooting war in Europe, increasingly damaging manifestations of climate change and the greatest supply-chain dislocation in a generation.
So, looking at inflation through the lens of global trade, it is unlikely that, even when we exit the more-likely-than-not coming recession, price stability will be restored. Every time central banks attempt to apply stimulus, it will have more immediate inflationary consequences. Flexibility is vanishing and so are the chances of any meaningful near-term reduction of the vast pots that global central banks have built up during years of quantitative easing.