The devil, or the deep blue sea?

Central banks are trying to tread the global economy’s increasingly narrow path, writes AICD chief economist Mark Thirlwell MAICD.

The idea that the economies they oversee are navigating a narrow path between inflation and recession has been embraced by the world’s central bankers. US Federal Reserve chair Jerome Powell has now warned several times that the path to a soft landing for the US economy has “narrowed” or been “getting narrower”. Bank of England governor Andrew Bailey has likewise cautioned for several months that the UK was navigating its own difficult, narrow path. European Central Bank officials have made similar pronouncements, as of course has Australia’s own Reserve Bank governor Philip Lowe, noting that the path to achieving a balance between returning inflation to target while “keeping the economy on an even keel” is “narrow” and “clouded in uncertainty”.

The ubiquity of the metaphor is testament to the widespread nature of the challenge, applying as it does not just to one advanced economy and its central bank, but to most of them. Hence, the Bank for International Settlements (BIS) — the central banks’ bank — explained in its 2022 Annual Economic Report earlier this year that the world as a whole faced the threat of higher inflation against the backdrop of elevated financial vulnerability. As a result, it had — yes, you guessed it — “a narrow path ahead”.

It was possible, the BIS said, that inflationary pressures could yet ease due to a decline in global supply chain bottlenecks and a reversal in war-induced commodity price hikes. That would allow for a reduction in the required scale of monetary policy tightening, delivering a more muted slowdown in economic activity and the contemporary global economy’s equivalent of the Holy Grail — a soft landing. However, the BIS continued, things could instead turn out badly. Persistent inflationary pressures might necessitate a more aggressive monetary policy response, triggering a steeper downturn — even a recession — as well as financial stress. So, no Holy Grail, but rather a stagflationary hard landing. That puts many of the world’s leading central banks between the devil of above-target inflation, unanchored inflationary expectations and lost credibility, and the deep blue sea of recession and financial crisis. Be too cautious with policy tightening and get the first outcome, too aggressive and get the second. Or be really unfortunate and get both.

Follow the leader

Sitting right at the heart of this policy challenge is the world’s most important central bank, the US Federal Reserve. It is the Fed’s interest rate decisions that have the biggest impact on global monetary and financial conditions — both directly and via the influence of the US dollar — and it is the Fed’s choices that exert the greatest influence on other central banks.

A big part of what’s been happening in global financial markets over recent months, then, is that participants have been trying to gauge the relative weight that policymakers in general, and the Fed in particular, place on avoiding the devil versus the deep blue sea. That choice informs just how aggressively they will push up interest rates and when they might stop doing so. Markets are also trying to estimate the likelihood that this choice will keep central banks safely on their narrow paths. As they process each new rate hike and accompanying policy announcement, they update probabilities and reprice assets accordingly. Hence, much of the market mayhem in September this year was triggered by the Fed sending the messages that rates were heading higher and that it was willing to tolerate a greater risk of recession. The Fed fears damnation more than drowning.

These circumstances also help explain why many of the world’s other central banks have been engaged in what sometimes looks like a massive game of “follow the leader”. Faced with the same challenge, they are adopting the same policy response — an aggressive tightening of monetary and financial conditions via rapid increases in policy rates. That collective decision has put the world economy in the midst of the most synchronised bout

of monetary policy tightening seen in at least half a century. Economists at the World Bank recently highlighted that the monthly number of policy rate hikes across the world economy hit an all-time high in July this year. But it’s not just the number of interest rate increases. It’s also their size — policymakers have increasingly been opting to move in 50, 75 and 100bp jumps rather than the more standard 25bp move.

This simultaneous — but formally uncoordinated — move to tighten policy creates the risk that international spillovers from national policy decisions will result in excessive tightening at the global level, driving the world into recession. Those same World Bank economists also noted worrying parallels with the 1982 global recession, which was triggered by a previous episode of synchronised monetary policy tightening across advanced economies. That episode did successfully tame inflation, but at a high cost in terms of lost jobs and output.

Financial vulnerability

Another complication has been the soaring US dollar, as higher US rates, plus the search for a safe haven in increasingly uncertain times, have supercharged international demand for the greenback. As a result, other central banks have had to be mindful that if they do not follow the Fed, their national currencies will tend to come under downward pressure, threatening to undermine their own fight against inflation. Some commentators have described this as a kind of “reverse currency war”, in which policymakers try to support their exchange rates against the greenback, as opposed to the old-school currency wars when nations sought the competitive advantage that came from a weaker currency.

Traditionally, tighter US monetary policy and an appreciating US dollar have been particularly bad news for financial stability in emerging markets, pushing up the price of imports and the cost of servicing debt in general, and of dollar-denominated debt in particular. But during the current tightening cycle the strain is also being felt across developed economies. The accumulation of very high public and private debt burdens left by both the aftermath of the global financial crisis and the COVID-19 pandemic, plus the distortions and risk-taking generated by a prolonged period of extremely low real interest rates, has left a legacy of financial vulnerability. As financial conditions have tightened, fractures have already appeared across the international financial system that go well beyond emerging market debt, including turmoil in UK bond markets and pension funds, pressures in corporate debt and credit markets, concerns over global property markets, and even liquidity problems right at the heart of the system itself, in the market for US Treasuries.

So yes, right now, the path ahead for the world economy does indeed look uncomfortably narrow.