Central Banks and Inflation: Where Are We Headed?

As central banks continue their headlong rush to the top, they are faced with a Cornelian dilemma: bring inflation down to 2% at the risk of triggering an unprecedented economic and financial crisis, or allow prices to rise, which would call into question their mandate and lead to social upheaval.

In the wake of last spring's banking crisis, stock market indices rallied sharply. As in 2020 and 2021, when the world was confined and the productive apparatus at a standstill, the stock market was back on the rise. The US flagship S&P500 index had risen by almost 20% in just a few months, and the CAC40 by around 10% over the same period. This rebound can be explained in part by the appeal of artificial intelligence, but above all by the support of central banks, particularly the US Federal Reserve. Last March, the latter introduced a new program enabling banks to borrow on ultra-favorable terms, with no regard for the real value of the assets pledged as collateral. Hundreds of billions of liquidity were injected into the interbank market, with new records being set every month. The Fed's balance sheet even increased for a time, despite persistent inflation. 

Although the markets have been in slight retreat for several weeks now, the price of financial assets as a whole remains extremely expensive given the state of economic activity.

On both sides of the Atlantic, corporate bankruptcies are multiplying, demand and consumption are falling sharply, money supply growth is slowing, but stock market indices are behaving as if everything is going smoothly. This disconnect with economic activity renders unintelligible the main purpose of financial markets: to finance the economy. Shouldn't the economy and finance evolve in tandem?

This separation is such that investors now react negatively when new jobs are created. A solid job market means that the economy is resilient and that inflation could persist. This means that central banks could proceed with further rate hikes, which would automatically lead to unrealized capital losses.

In the meantime, inflation is easing, unemployment remains historically low, and banking stability seems assured according to the central banks' recent stress tests. So all is well, Madame la Marquise? This scenario doesn't look set to last. Inflation remains well above the 2% target, and inflation excluding the most volatile products (energy and food) is still very high. The banking stress tests also judged banks to be "resilient" in terms of solvency risk (long-term), rather than liquidity risk (short-term). The bank failures of last March, like those of 2007-2008, were linked to liquidity crises. 

In recent months, monetary institutions have stepped up their tightening policies in an attempt to stem the sharp and persistent rise in prices. They have intensified the reduction of their balance sheets and raised interest rates further. By extension, these developments have led to a permanent and almost historic rise in certain market rates: the US 10-year rate has now reached 4.5% (compared with 3.5% at the time of last March's banking crisis), the 30-year fixed rate for mortgages is approaching 8%, and the rate for "investment grade" companies exceeds 5.5%. In Europe, long rates are rising steadily, not least in France, where the government plans to borrow a record 240 billion euros in 2024. 

Above all, these increases entail a short-term risk, affecting the value of bonds currently held. Bonds are used as collateral in many interbank transactions. In fact, since their value depends on prevailing interest rates, these assets depreciate when rates rise, forcing investors to provide more liquidity. Forced sales then follow, which is why the pace of equity sales is currently the fastest since December 2022. At the same time, numerous hedge funds are engaging in massive short selling (around 600 billion) on the world's largest bond market: US government bonds.

To avoid any contagion, while the Fed remains almost powerless given its need to fight inflation, the US Treasury has announced plans for a major government bond buyback program. According to Bloomberg, its implementation is scheduled for early 2024. This would be the umpteenth intervention by the public authorities, which would not be without consequences. This support, like its predecessors, increases the consequences of a future crisis by artificially boosting asset prices, and accelerates banking concentration, wealth inequality and the disconnection between markets and the real economy. Unlike financial institutions, households and businesses (especially small and medium-sized ones) are not benefiting from this liquidity, but are suffering from the rising cost of credit. What's more, the rising cost of living is leading to an accelerated impoverishment of a large proportion of the population, especially those on the lowest incomes.

However, the monetary tightening cycle should soon come to an end. At its last meeting, the Fed decided not to raise interest rates, as did the Bank of England, despite annual inflation of over 6%. These choices are supported by the idea that inflation can now only slow down, but above all by the fear of triggering a new banking crisis. Yet, just as in the 1970s, an acceleration in inflation over the coming months remains possible if central banks are lax. Especially as real interest rates are still extremely low (negative in the eurozone). And in the current geopolitical context, the reduction in oil production by several countries, including Saudi Arabia and Russia, could have significant inflationary effects, as witnessed by the acceleration in inflation in the United States last month. 

From the point of view of financial stability, history shows that it's only when central banks (primarily the Fed, the world's central bank) stop raising interest rates that the economy really starts to deteriorate and financial instability intensifies. The effects of monetary tightening are gradual, generally taking between one and one and a half years. In addition, the increasing digitization of payment methods is leading to fears of stealth bank runs (as demonstrated by the bankruptcy of the crypto-currency company FTX), as deposits can be withdrawn in record time.

Given the world's historic indebtedness, the stakes for central banks are quite singular. According to a new report by the Institute of International Finance, global debt has reached $307 trillion, $100 trillion more than just ten years ago. And U.S. public debt, the symbol of the globe's growing indebtedness, is now increasing by around one billion every 60 minutes. Rising interest rates (more or less everywhere in the world) are increasing the cost of debt, putting an end to several years of financial illusion, in the words of former IMF Managing Director Jacques de Larosière.

As central banks choose to fight inflation at all costs, this credit bubble is likely to burst eventually. Monetary institutions want to maintain confidence in money, which has always been fundamental. As a result, current monetary policy will continue until a major financial and economic crisis (far greater than that of 2008) occurs. At a time when unemployment will have risen sharply, new issues will emerge from this tragedy, including the risk of increasing authoritarianism, as in the aftermath of the 1929 crisis.

To avoid such a scenario, and as Victor Hugo liked to say, to avert catastrophe, we need to embark on a paradigm shift as quickly as possible. The introduction of new monetary creation measures is one solution, but it will never replace a policy in which morality always and everywhere takes precedence in decisions, particularly economic ones.