Central banks must try to tame ‘Biden’s beast’

It’s through: Wednesday night, US President Joe Biden’s massive bailout package completed his long walk through the US Congress virtually unscathed. $ 1,900 billion, an amount that corresponds to more than 8 percent of the American economy, will soon find its way to American citizens and companies.

The amount is so colossal that the OECD, the club of 37 industrialized countries, calculated on Tuesday that it will increase the growth of the entire world economy by a full percentage point.

Now the time has come when the American and the world economy will have to digest the package: like a python processes enormous prey. The boost comes on top of the support that other countries give their economies. And that is in addition to the spending impulse that the end of the pandemic will most likely bring about.

A buying wave can push up prices. Certainly also because it is precisely in those sectors where the hardest blows were made, such as the hospitality industry and tourism. These entrepreneurs will, if possible, charge higher prices, if only to recover more quickly. The increasing demand is causing potential capacity problems for suppliers. And before you know it, prices will go up across a broad front from next summer.

Investors’ fear of inflation has been visible in recent weeks. Government bond yields rose in both the US and Europe. Bonds are very sensitive to inflation. This erodes the value, which is why an investor wants a higher interest rate as compensation. Inflation often seeps through between highly interconnected economies, such as those of the US and Europe. Ten-year US Treasury yields rose from just over 0.9 percent early this year to a peak of 1.6 percent last week. Yields on German ten-year government bonds climbed from minus 0.6 to minus 0.3 percent.

This poses a dilemma for central bankers: higher interest rates can frustrate the still fledgling economic recovery. But if interest rates are too low, inflation can get out of hand. In recent days, the two (for the time being) most important central banks in the world, the US Federal Reserve and the European Central Bank, waved away inflation fears. Their main message: economic recovery is paramount. And so interest rates must remain very low.

ECB is stepping up a gear

The ECB in particular was very outspoken after a meeting on Thursday. ECB President Christine Lagarde said in a press conference that while the Biden package will have an “impact” on growth and inflation in the eurozone, it should probably not be “overestimated”. Later this year, Lagarde said, the ECB may meet its inflation target of just below 2 percent for the first time in a long time, after inflation was well below it for years. But “we’ll see through that,” said Lagarde, because it will have to do with “technical and temporary factors.” For example, a temporary German VAT reduction is coming to an end and the always volatile oil prices have been rising for some time now.

The ECB board decided Thursday that it will buy more government and corporate loans in the coming months to prevent interest rates from rising further. With the so-called ‘pandemic emergency buys’, the ECB is pushing interest rates on the bond market in the corona era, in order to keep borrowing costs low for governments, companies and banks. This is how the economy must get going again.

Weekly ECB bailouts – around EUR 12 billion since the beginning of this year – are ramped up “significantly” to an as yet unknown amount. Lagarde said the central bank still has $ 1,000 billion to spend from a $ 1,850 billion buy-back package running until March 2022. The economic situation in the eurozone remains highly uncertain, she said, referring to the “dynamics of the pandemic” and ” the pace of vaccination campaigns ”.

The US economy is already in full swing

Europe is lagging behind the US when it comes to vaccination and therefore threatens to stay in lockdowns for longer. The eurozone economy will contract again this quarter, according to the ECB. The recovery will follow “in the course of this year”, while in the US the economy is already running at full speed.

The OECD, which this week pushed for hurry with the vaccinations, forecasts economic growth in the eurozone of 3.9 percent for 2021, 0.3 percentage points more than was forecast at the end of last year. This growth clearly lags behind the projected growth in the US (6.5 percent). In addition, the eurozone is struggling with ever-growing differences between member states. Both Spain and Italy have not even caught up with the corona damage at the end of 2022. France is close, while Germany is already on top of it for a long time. If the ECB allows interest rates to rise too much, a country like Germany can have it, but a country like Italy cannot.

The US Federal Reserve – the central bank of one country – has an easier time in this regard, but the dilemma between economic growth and inflation is the same. Although US inflation over February was more subdued than expected on Wednesday (1.7 percent), the financial markets have seen an undercurrent of unrest about the inflation outlook. Since the Fed has a dual mandate – the pursuit of full employment and price stability, one of these goals is under threat.

ING analysts see US inflation spikes to between 3.5 percent and 4 percent in the summer. After that, an inflation rate of between 2.5 percent and 3 percent is expected for several years.

Such expectations have not missed their impact on the financial markets. Bond investors, anxious as they are about loss of value due to inflation, are now more likely to ignore government debt. This became clear on February 25, when an auction of $ 62 billion worth of new seven-year government bonds went very difficult.

This week, in which 120 billion in government bonds are put on the market, promises to be better. But that in no way diminishes Fed Chairman Jerome Powell’s dilemma. The Fed has an official interest rate of almost 0 percent and is still buying $ 80 billion a month in government bonds. Any sign that this amount is being reduced will push up the effective interest rate on government bonds. But if the Fed maintains its policy, there is a risk that inflation will get out of hand. In response, interest rates on government bonds are also rising, because investors then fear that the central bank is doing too little against inflation.

Threat ‘taper tantrum’

So Powell can’t do it right at the moment. Last week, he said in a press conference that he would not make any changes to monetary policy. The market reacted with a wave of government bonds. The prices of government bonds fell and the effective interest rates on them – disproportionate to the price – rose.

Analysts have already drawn parallels to what happened in July 2013. Then the Fed also bought up government bonds on a large scale and announced that it would phase out the monthly buy-back amounts. tapering mentioned. What followed was a fierce market reaction with a sell-off of government bonds, which went down in history as ‘taper tantrum’. The interest on ten-year government bonds exploded from 1.5 percent to above 3 percent.

No one – in the US and in the eurozone – can afford such a sharp rise in interest rates now. The debts of citizens, companies and governments are far too great for that. Central bankers are now walking on eggshells. Whether that is out of conviction or paralysis will become clear later this year when the economy reopens.
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