The dawn of the quantitative tightening era?


Currently, most market participants would agree that rising inflation and a tightening of liquidity is the greatest threat to financial markets.

However the broken global supply chain is causing persistent inflation, Milton Friedman described inflation as a rise in the quantity of money that exceeds the increase in total output. In the wake of the Canadian and Australian central banks starting the tightening cycle, the more important central banks - Fed, ECB, and BoJ should follow suit and end the liquidity-fueled party in financial assets.

For sure, the direction of travel is clear. Inflation has indeed jumped higher and has stayed elevated for longer than many central bankers had anticipated earlier this year. It is possible that disorderly supply chains will ripple through the global economy and create uncomfortably high inflation. Furthermore, the recovery from the Coronavirus has been wonderful, which makes it sensible for central banks to begin reducing emergency stimulus, and even start raising interest rates cautiously.

However, the current narrative feels a bit too elegant. As if it emerged fully formed from the fevered dreams of long-frustrated hedge fund managers or crypto utopians who have been wrongly predicting runaway inflation for years.

It is still too early to worry about serious inflation, aggressive central bank action, and financial market chaos.

As a result of hedge funds being forced to liquidate trades, the recent short-term bond sell-off has been violent. The longer-term government bond market remains relatively stable. It reflects the belief that inflation is accelerating but will ultimately return to the levels seen over the last few decades.

In any case, the factors that have driven down inflation since the 1980s - such as globalization, technological advancements, demographic shifts, debt burdens, and weakening the bargaining power of workers - are not likely to reverse.

A common message among bond markets is that the real risk comes from central banks losing their nerve and overreacting to something they have only minimal control over.

Increasing rates won't solve congestion in ports, logistical bottlenecks, labor shortages in selective industries, or underinvestment in energy infrastructure.

However, doing so prematurely could hinder the economic recovery. Except for some notable exceptions, it still seems unlikely that anyone would make such a mistake. 

The Fed, the European Central Bank, and the Bank of Japan are the three central banks that matter the most. Even if inflation does not immediately begin to ease, none is likely to slam on the brakes any time soon. The new monetary regime is about to begin, but it will likely resemble the last one uncannily.

by Gurleen Kaur

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