The world can kiss goodbye to an economic soft landing. Western central banks are on a misguided mission to restore their damaged credibility, tightening monetary policy violently after the post-pandemic recovery has already wilted and output is nearing contractionary levels.
Britain’s fiscal blitz has the luck of timing. It is a counter-cyclical stimulus, cushioning some of the blow, even if it risks rattling bond vigilantes, and even if it is wasteful in subsidies for the affluent.
Critics say the energy bailout will cap inflation in the short run but stoke more inflation in the long run, to which one can only reply, like Keynes, that in the long run we are all dead. World events are going to wash over such quibbling with a torrential deflationary force.
The central banks are pushing through with triple-barrelled rate rises after the inflation fever has broken; after the commodity boom has deflated; and after key monetary indicators on both sides of the Atlantic have turned negative. They are prisoners of lagging indicators.
If the US Federal Reserve and the European Central Bank press ahead with signalled rate rises, this episode may go down as a policy error of the first order.
It is the mirror image of misjudgments two years ago when they created too much money to cover naked fiscal deficits. The Bank of England will no doubt suffer abuse from inflationistas, but in my view it was courageous to stick to a 50-point rise on Thursday and resist the monetary chest-beating in vogue.
Raising rates to defend your currency does not always work in any case, as the Swedish Riksbank found this week. It went for a jumbo 100 points yet still failed to stabilise the krona, weaker this year even than sterling and the euro.
While the British media dwells on sterling, the greater story in global markets is the extreme weakness of currencies in China, Japan, Korea, and Taiwan. The yen is at a half-century low in real terms against the dollar, triggering outright exchange intervention by the Bank of Japan on Thursday. The Chinese yuan has weakened beyond the psychological line of 7.0, risking capital outflows akin to the currency crisis of 2015.
Exchange rate ructions on this scale by a quartet of global creditors with $5 trillion (£4.4 trillion) of foreign exchange reserves are invariably harbingers of trouble in global finance. Some of us remember the 1998 crisis when a chain reaction blew up the hedge fund Long Term Capital Management, forcing the Greenspan Fed into a dramatic retreat.
Markets were expecting the Fed to raise rates by 75 basis points this week. They did not expect its chairman Jerome Powell to lock himself so irreversibly into further rises. “There is no off-ramp from this aggressive stance. They are virtually bound to do another 75 at the November meeting and then 50 in December,” says Tom Porcelli from RBC Capital.
At the same the Fed has begun draining $95 billion a month of dollar liquidity through quantitative tightening. This squeezes the offshore dollar lending markets. It is slow torture for borrowers in the developing world with dollar liabilities.
The Fed is working from a New Keynesian model that ignores the quantity theory of money. It loosely equates $2.5 trillion of QT to just two quarter point rate rises. There is a contradiction in this claim. The Bernanke Fed long insisted that quantitative easing was a necessary and powerful stimulus: now the Powell Fed asserts that QT is just background noise.
Markets think otherwise and will act accordingly. They are acutely-sensitive to the ‘flow’ effects of liquidity.
Michael Darda from MKM Partners says the Fed’s real policy rate has risen 360 basis points over the last seven months, “something that has occurred only three other times in history, all associated with deep recessions and bear markets.”
The Fed is fixated on legacy inflation, badly distorted at this juncture by the property component in the price index known as "shelter". But shelter is sticky. It lags the actual housing market by 18 months.
This has led to a surreal situation: a rise in 30-year fixed mortgage rates to 6pc over the last year has sent the property sector into free-fall. The NAHB housing index peaked last December and has been dropping at a steeper rate than during the subprime bust in 2007. If that is inflationary, I will eat my hat.
Mr Darda says the Fed risks inflicting serious damage if it ploughs ahead with stated intentions. He advises clients to batten down the hatches for the coming storm and buy US Treasuries as a safe-haven.
Powell has more or less stated that a slump is the necessary price that America must pay to curb inflation, or what his model deems to be inflation. “No one knows whether this process will lead to a recession or, if so, how significant that recession would be,” he said.
Monetarists beg to differ. Both narrow and broad money have been contracting for several months. In real terms, they have collapsed. Simon Ward from Janus Henderson says broad M4 money in the G7 bloc peaked 20 months ago and is now below trend levels. “Inflation risks are fading fast,” he says.
You could argue that Mr Powell’s recession is already here. The US economy shrank over the first two quarters. The Atlanta Fed’s instant tracker of GDP has dropped to 0.3pc (annualised) this quarter. The New York Fed’s measure of inflation expectations three years ahead has fallen from 4.2pc to 2.8pc. It is back to normal levels.
The European Central Bank’s stated plan for jumbo rate rises is even more questionable given that Europe’s inflation is chiefly caused by an external energy shock, beyond central bank competence. High fuel costs cause deflation for the rest of the economy.
Deutsche Bank expects the eurozone to contract by 3pc over the winter, worse than the peak-to-trough decline in the Lehman crisis. It expects German GDP to fall by 3.4pc next year.
One day people will look back and ask what possessed the ECB’s governing council to keep tightening hard into the teeth of this storm. The decision will live in monetary infamy alongside Jean-Claude Trichet’s rate rise in July 2008, when the world’s financial system was visibly keeling over.
Britain is a little boat tossed around on these turbulent high seas. But it is not defenceless. If it can avoid the monetary machismo all around and launch its fiscal stimulus early, it might survive this global downturn in better shape than many presume, and perhaps near the top of the G7 for another year.
Inflation will abate gradually of its own accord across the Atlantic world, without the need for a punishment beating by central banks with bad models. Boom-bust monetary policy is frankly a scandal.