Soapbox: Tough Snake

In Shakespeare’s tragedy Macbeth, Macbeth ponders in Act Three his murder of King Duncan. Macbeth has seen a vision of the bloody dagger that he used in the murder and is filled with gloom. Lady Macbeth instructs her husband to cheer up and says “what’s done is done”. To which he responds “We have scorch’d [slashed] the snake, not kill’d it”. Macbeth means the job is only half-done; others remain alive who will challenge his effort to become King.

Central banks today risk of succumbing to a different tragedy – they may have only “scorch’d” their snake, inflation, and not killed it.

The inflation snake spooked US investors last week, with the S&P 500 index losing almost 3% during the week and the Nasdaq Composite, a tech-heavy index, dropping more than 3%. The falls were prompted by data showing the US personal consumption expenditure (PCE) price index went up in January by an annualized 4.7% , sizeably bigger than average forecasts of a 4.3% rise. The reason equity investors reacted so negatively to the unexpected rise in the PCE (which is the US government’s preferred inflation measure, and which strips out food and energy on the basis that those two categories can have wild price swings) is that given the apparent ‘stickiness’ of inflation more interest rate rises are expected, meaning further tightening (making more expensive) of credit, in turn limiting investment. Inflation is proving slipperier than a rattlesnake; let’s hope its bite is not as bad as a black mamba’s. President Joe Biden said the latest PCE figures showed “we have made progress on inflation, but we have more work to do”.

How much work?

America’s central bank, the Federal Reserve, like many other central banks, has the task of trying to maintain stable prices. It did a very poor job of that in 2021-22, with Jerome Powell (the Fed’s chairman) reiterating that inflation was “transitory”, a view given frequent backing by the US Treasury Secretary, Janet Yellen. The UK’s central bank and the European Central Bank were no better in their forecasts about inflation. Core inflation in the Eurozone for this February is expected to remain at an annualized 5.3%, the highest on record. The Eurozone’s sticky core inflation (which excludes food and fuel) is expected to endure throughout 2023. Some economies of the Eurozone, notably Germany’s, are delivering such poor results that the whole zone’s Gross Domestic Product (GDP) for 2022 could well be revised down in March. As in the UK, the Eurozone may already be at the start of its own bout of stagflation. Consumer confidence in Germany is now at a very low level. Sentiment among European consumers more generally has improved, according to the European Commission; in February, it reached the dizzy height of minus 19, its highest since the Ukraine war started but below its long-term average. ‘Confidence’ is perhaps the wrong word here; ‘less desperate’ might be better.

Central banks want to hit a “Goldilocks” spot – the place where their economies are not running too hot (leaving inflation remaining high) nor too cold (slipping towards a recession). They ‘target’ inflation, aiming to maintain it around 2%/year. That’s easier said than done. The index of wholesale costs in the US – the measure of producer prices – rose by 0.7% in January, higher than expected and the most since June 2022. Sweden’s core inflation in January rose to an annualized 8.7%, against expectations of 8.2%. These are just straws in the wind so far; could they become a blizzard?

It’s a little late

Some experienced financial commentators are already predicting that inflation will burst higher this year. The snake has been “scorch’d” but not killed, they argue. The reason for this they claim is that money supply has exploded since 2008, with governments dealing with the 2008 financial shock by Quantitative Easing (QE) and with the Covid-19 pandemic by handing out trillions in ‘support’ packages. The Bank of England’s (BoE) potential loss from its QE programme might be as much as £200 billion, which (of course) the poor old taxpayer will have to pay. According to some the US money supply has risen by 40% since 2000. There is, continues this argument, a significant time-lag between the ‘new’ money entering the system and the impact it has on prices, with too much money chasing a limited supply of goods. It takes time for all the new money to get spent, and prices will concomitantly take time to rise.

In this inflationary bout so far we have seen central banks raise their base interest rates very gently. The fact that we have become accustomed to very low or almost zero interest rates has duped us into thinking that the cost of borrowing is forever going to be low. Despite the ‘shock, horror’ headlines that follow each small rate increase, even as inflation has risen to multi-decade highs, rates in the US, the UK and the Eurozone have been negative, i.e. lower than inflation. Central bankers don’t really fear the snake, it seems.

When inflation in the US went above 14% in 1980, the then chairman of the Federal Reserve, Paul Volcker, pushed the Federal Funds rate (America’s base rate) to a peak of 20% in June 1981. Volcker was determined to kill the snake. He did – but the inflation took until the second half of the 1980s to drop to 3.5%, and at a cost of creating the 1980-82 recession in which the unemployment rate went up to more than 10%, against the current unemployment rate of 3.4%.

Giving our central bankers the benefit of the doubt, one might say the reasons why current inflation ‘snake’ exists are not fully understood. But being less generous one might say that pinning the blame on the 2008 great financial crisis, or Covid-19, or the Ukraine war and its subsequent energy price spikes – all of which are regularly trotted out – is grotesquely misleading.

It’s the way that policymakers handled the 2008 crisis and handled the Covid-19 pandemic, trying to paper over cracks, paying people to stay at home, keeping zombie firms in business, bailing out collapsed banks – all of which required trillions of ‘new’ money to be created – which created this snake. The energy price spikes following Russia’s invasion of Ukraine were, to some extent, self-induced, as the West imposed sanctions (necessary, no doubt) on the Russian aggressor. All that can be said with any certainty is that, so far, policymakers still prefer to pretend that the snake can be killed without spilling blood; so far they have been under the delusion that inflation can be quashed without causing pain.