TD₿: Inflation or Recession by Lyn Alden
TL;DR Central banks face a dilemma: how to fight inflation, without leading us into a recession.
To say that central banks are in a Catch-22 these days would be an understatement. After decades of policy errors and keeping interest rates artificially low, central banks are struggling to reel in inflation without causing an economic crisis in the process.
With inflation raging, the Federal Reserve has gone on one of the most aggressive tightening cycles in its history, spiking interest rates in an attempt to cool off the red-hot economy.
The problem is that this puts pressure on other central banks to keep up with the Federal Reserve’s pace of rate increases, or else they risk their currencies losing value when measured against the dollar.
The other problem is that with debt levels as high as they are, central banks have to be careful not to tighten financial conditions too quickly without placing immense pressure on their over-leveraged economies.
These dynamics all came to the surface this week in the United Kingdom. The Bank of England has been raising interest rates to combat record-high CPI inflation and protect its currency from losing value against the dollar.
Things started to break earlier this week when the British pound suffered a historic drop in value against the dollar, dropping to an all-time low exchange rate. It is now down -19.70% YTD.
From there, the yields on the United Kingdom gilts shot up as investors responded to the currency devaluation and likely fear that a risk of a severe recession in the UK was imminent. The 10-year UK gilt crossed 4.4%, the highest level since 2008.
This crash in the price of these bonds immediately caused issues within the UK economy. It is being reported by the Financial Times that "Thousands of pension funds faced urgent demands for additional cash from investment managers ... to meet margin calls, after the collapse in UK government bond prices blew a hole in strategies to protect them against inflation and interest-rate risks."
This led to the Bank of England reversing course and intervening in its bond market, buying unlimited amounts of long-dated gilts to stop the bleeding. The Bank of England said in a statement, "Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability…This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy."
So now, the BoE is performing Quantitative Easing to try to prevent an economic crisis from occurring while UK CPI inflation sits at double-digits for the first time in 40 years.
This is the conundrum that all central banks face. How do you raise interest rates to combat inflation and protect the value of the local currency without causing a systemic crisis with these debt levels?
This dynamic is exactly what Lyn Alden was talking about back in May in her newsletter titled “Inflation or Recession.” (05/2022)
The UK is showing the world how fragile these developed economies have become after years of ultra-easy monetary and fiscal policy.
BoE is now performing QE amidst record-high inflation. The question is — will the Fed be forced to do the same?
Tick tock next block,
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