By Dint of Acting As Firefighter Arsonists, the Fed and the ECB Have Burned Themselves …
... and we will have to pay the price.
For those who take the time to follow the economy closely enough, one reality is obvious. This reality is certainly one of the worst news of the last few years. While in normal times, central banks are supposed to be the guardians of the temple, i.e. of economic and financial stability, they have become dangerous firefighter arsonists. This is even more true for the Fed and the ECB.
Indeed, under the guise of wanting to support activity, they have only thought of pleasing governments and financial markets.
To achieve this, the Fed and the ECB have activated a plethora of money printing machines, which have produced more and more perverse effects, namely the stock market, bond, and real estate bubbles, but also a strong increase in inflation. As a result, inflation has soared durably and well beyond the targets of the Fed and the ECB, showing that the latter is completely overwhelmed and even trapped by these inflationary pressures.
The Fed and ECB have wasted precious months refusing to admit the obvious about inflation
Despite this evidence, Fed Chairman Jerome Powell and ECB President Christine Lagarde continued to trumpet for months that everything was fine, that they had the situation under control, or that the increase in inflation was transitory. However, all the leading indicators of inflation, and in particular the year-on-year change in producer prices, have been rising steadily since the spring of 2021.
Therefore, denying this reality and burying one's head in the sand was a dangerous strategic mistake. Inflation is indeed like toothpaste: once it is out of the tube, it cannot be put back in. In other words, if inflation gets too out of hand, it is then very difficult and economically expensive to reverse the trend.
And, unfortunately, this is exactly what happened. Certainly, in the US, Jerome Powell has made his mea culpa by the end of 2021. Better late than never. However, by stopping its ultra-accommodating policy in a hurry, the Fed has caused a panic in the financial markets and has broken the growth of the American economy very sharply.
This denial is now paying off and the ECB has been even slower to act than the Fed
The ECB's behavior was even more comical and therefore more dramatic. Indeed, despite the obvious inflationary surge in the Eurozone, which of course worsened with the explosion of commodity prices, the President of the ECB, Mrs. Christine Lagarde, not only refused to make her mea culpa but also continued her ultra-accommodating monetary policy until July 21st, 2022.
On that date, after more than eight months of denial, the ECB finally decided to raise its refi rate. On September 8, 2022, it continued to wake up, raising its refi rate by 75 basis points. And this, while the Eurozone is falling back into a severe recession.
Faced with this belated and painful awakening of the ECB, two main reflections are in order. On the one hand: What a waste of time! Let's not forget that the ECB's inflation target is 2%, while actual inflation in the Eurozone was already 8.6% in June 2022, and 9.1% in August 2022 (a historical record) and will soon be above 10%...
Such a discrepancy between the ECB's main objective and reality is not likely to improve the credibility of the Eurozone's issuing bank, which is already particularly weak.
On the other hand, this tightening, which is essential if only to halt the fall of the euro, especially against the dollar, comes at a particularly bad time, since it coincides with the return of the Economic and Monetary Union to recession. In other words, by taking too long to remove the drip, the ECB has helped plunge the Eurozone into stagflation. And that's not all, because the necessary continuation of monetary tightening on both sides of the Atlantic will inevitably lead to a new financial crisis.
And this, because of a permanent denial of reality, which will now have to be repaired with a bang …
The Fed and the ECB have lost credibility by forgetting their three main objectives
Let's never forget that like many central banks around the world, the Fed and the ECB have three main objectives:
Limiting inflation.
Avoiding recessions.
Ensuring financial stability.
In 2020, the health crisis resulted in zero or even negative inflation in some countries, a historic two-quarter recession, and a stock market crash lasting about a month. Faced with these three disasters, central banks were obliged to react by lowering their key rates and printing money, which made it possible to reduce interest rates on government bonds despite the explosion of public debt.
A historic crisis calls for a historic monetary policy!
The only problem is that, since 2021, the central banks have fallen into their trap: after having used the money printing press excessively, they feared that stopping it would result in a sharp economic slowdown and a collapse of the financial markets.
In this context, they took a particularly high risk, that of letting inflation run away, hoping that it would miraculously fall back. But miracles are rare in economics, especially when it comes to inflation. And especially when the leading indicators of inflation were up for months and even before the war in Ukraine.
Final Thoughts
Crazy as it may sound, central bankers have therefore adopted the old habits of politicians, i.e. favoring clientelism and short-termism at the expense of credibility and longer-term objectives.
In this dangerous game, one thing is certain: there are only losers: growth, purchasing power, financial markets, and, of course, companies and citizens, not to mention the central banks themselves, which have lost credibility.
When you play with fire, you end up getting burned, especially when central banks become dangerous firefighter arsonists.
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