Opinion: Central banks and markets are experiencing a secular awakening

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Opinion: Central banks and markets are experiencing a secular awakening

For the economy and global markets, the past week has marked a definite “awakening”.

As central banks’ fine words about fighting inflation gave way to more meaningful policy actions, there was a first awakening with the realization that we were undoubtedly transitioning to a new regime, more challenging for financial conditions.

And because this transition comes so late there has been a second awakening – the recognition that there is no hiding the difficulties it poses for policymakers, families, companies and markets.

Just look what happened last week. In the United States, the Federal Reserve (US Central Bank) raised benchmark interest rates by 0.75 percentage point on Wednesday (15). Not only did this go against his own guidance of a 0.50 point increase, it also negated what his own chairman, Jay Powell, had voluntarily ruled out a few weeks earlier in saying that a 0.75 point increase was not being actively considered. by the central bank.

There is now no denying that, after a long period of resistance, the world’s most powerful central bank has loudly acknowledged that it has no alternative but to face inflation harder, regardless of the impact on markets.

The following day, in Europe, the Swiss National Bank (SNB) raised the rate by 0.50 point, surprisingly dissociating itself from the European Central Bank. This crystallized what many were beginning to suspect. The SNB is a central bank that has long been used to fighting the appreciation of the franc. But after seeing what happened in Japan and the UK, he joined the growing number of his peers who want to avoid a currency depreciation that would make winning the inflation battle even more difficult.

And all of this came in the week the Fed began implementing the second element of monetary policy tightening — the shrinking of its $9 trillion balance sheet, bloated by a protracted asset purchase program to support markets.

It is undeniable that, after years of massive injections of liquidity and minimal interest rates, the world is subject to a general tightening of financial conditions that feeds on itself.

It is not a cyclical phenomenon that will soon trigger mean-reversion forces. It is a secular regime change imposed on reluctant central banks by rising inflation that threatens livelihoods, exacerbates inequality and undermines financial stability.

As it is late, this change comes with an increased risk of collateral damage and unintended consequences. That was evident last week as growth fears gripped markets and more analysts jumped into the recession camp.

Awakening is an important part of navigating the risks facing the global economy. But the process cannot and must not stop here. There is more to be done if the intention is, as it should be, to limit the damage of the historic policy error initiated last year by the Fed, when it stubbornly maintained its erroneous view of inflation as transitory.

To continue to regain political credibility, the Fed needs to follow the ECB’s lead and explain why it was so wrong in its inflation forecasts for so long and how it improved its forecasting capabilities.

To play its intended and much-needed role as an honest adviser, the Fed needs to follow the Bank of England and be frank and open about what’s to come in the economy. As he persists in failing on both, it is not surprising that so many economists, including former Fed officials, have complained last week that the central bank’s revised economic forecasts remain unrealistic.

In 2016, I published “The Only Game in Town” [O único jogo na cidade], which analyzes what was already an excessive and prolonged reliance on central bank intervention. I detailed why, over the next five years or so, the global economy and markets would likely face a “T junction,” where an increasingly unsustainable path gives way to one of two contrasting roads.

One led to high, inclusive and sustainable growth, the other to recession, greater inequality and financial instability. The sooner policymakers recognized the parting of the ways and acted accordingly, the more likely the better road would prevail.

Unfortunately, this was not done. As such, the global economy today faces disruptions to growth, damaging inflation, increased inequality and unsettling volatility in the financial market. Having failed to act to prevent this unfortunate turn, policymakers must now act more decisively to limit the overall damage and better protect the most vulnerable segments of our society.

Translated by Luiz Roberto M. Gonçalves

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