Pity the central bankers: No easy way to stop rising inflation or bubble-bursting

One has to pity Federal Reserve Chairman Jerome Powell and European Central Bank (ECB) President Christine Lagarde. Last year, after having spared their respective economies from depressions with the boldest of monetary policy actions in the wake of the pandemic, they now find themselves faced with the most unpalatable of economic policy choices. For different reasons, both find themselves damned if they begin to taper their aggressive bond-buying programs and raise interest rates. However, they also find themselves damned if they do not begin monetary policy tightening.

It would be an understatement to say that Powell and Lagarde both reacted with unprecedented boldness to the economic collapse and the seizing-up of financial markets in the wake of the COVID-19 pandemic. They both did so by driving down interest rates to their zero lower bound and by engaging in truly massive bond-buying programs.

Whereas, following the September 2008 Lehman bankruptcy, it took then-Fed Reserve chair Ben Bernanke’s Fed six years to increase the size of its balance sheet by bond buying by around $4 trillion, it took Powell’s Fed less than a year to do nearly the same thing. For her part, Lagarde did something similar by increasing the size of the ECB’s balance sheet from $5 trillion at the start of the pandemic to its present level of around $9.5 trillion. Lagarde also broke new ground for the ECB by abandoning its capital key in deciding which of its member countries’ bonds to buy.

While the Fed and the ECB’s bold policy actions did succeed in stabilizing financial markets and preventing an economic depression, they did so at the cost of creating a global “everything” asset and credit market bubble.

Global equity valuations soared to levels reminiscent of those prevailing on the eve of the 1929 stock market crash. Similarly, U.S. housing market prices, as measured by the Case-Shiller index, rose to levels well above those prevailing in 2006 at the peak of the earlier U.S. housing market bubble. Meanwhile, credit flowed freely at very low interest rates to borrowers with very poor credit quality both in the advanced economies and in the emerging market economies.

The difficult policy challenge for both the Fed and the ECB now is that, at the same time they have to contend with asset and credit market bubbles, they also have to contend with economies that are at risk of overheating.

In the United States we already are seeing disturbing signs of inflation as a result of a combination of the largest peacetime budget stimulus on record, a highly expansive monetary policy, a large amount of pent-up demand in the economy and both product and labor market supply-side problems. Particularly disturbing are the facts that, in the first four months of this year, consumer prices increased at an annualized rate of 6.25 percent, while for the year as a whole, inflation expectations as measured by the Michigan Consumer Survey have risen to 4.6 percent. 

Similar signs of overheating and inflation are now starting to emerge in Germany, Europe’s largest economy. The German economy is now well on its way to recovering to its pre-pandemic level while German inflation is already running at a level that is meaningfully above the ECB’s close to 2 percent price inflation target.

The Federal Reserve is now faced with the most unenviable of policy choices. If it were to scale back its bond-buying activities and raise interest rates to prevent the economy from overheating, it would risk bursting the global “everything” asset price and credit market bubbles. That is because those bubbles are premised on the belief that interest rates will stay low forever. Yet, if it does not dial back its current expansive monetary policy stance, it risks inviting further inflationary pressure and adding more froth to the financial markets. Such a course would set the economy up for an even harder economic landing when the music eventually stops. 

The ECB finds itself in a similar policy dilemma. If the ECB were to stop its bond-buying program and raise interest rates, it would risk inviting another round of the sovereign debt crisis, this time centered on Italy, the Eurozone’s third largest economy. This is particularly the case at a time that highly indebted Eurozone countries with very poor public finances, like Italy, Portugal and Spain, are all being kept afloat by massive ECB buying of their government bonds. Yet, if the ECB does not dial back its expansive monetary policy, it risks exacerbating inflationary pressures, especially in Germany, the ECB’s largest shareholder. 

All of this does not bode well for the longer-run U.S. and European economic outlooks. This would seem to be especially the case at a time that both the Fed and the ECB are in inflation denial. It would also seem to be the case considering that both institutions have a long track record of avoiding difficult decisions and of choosing instead to keep kicking the can down the road. 

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.