Last Sunday, we saw the music icon Elton John take the stage at the iconic Pyramid Stage at Glastonbury for the first, and likely, the last time. This performance might be the last one he ever does in the UK as part of his interrupted final world tour. His career has spanned decades, starting with the classic “Your Song” up to recent chart-topping remixes, like “Cold Heart”. Whilst this might be his final act, investors continue to ponder when the final act for central banks may be in this hiking cycle.
This week marked the annual European Central Bank (ECB) Forum in Sintra which saw some of the key central bankers meet to discuss policy. So far, the hiking cycle has very much felt like “Rocket Man” compared to previous cycles over recent decades. Yet despite taking this “Bennie and the Jets” approach, the economy has so far been showing it is still standing. Although Guns N’ Roses took the Glastonbury stage the night before and tried to scream for some “Patience”, it seems as though central bankers listened to Lana Del Ray instead: perhaps they hope their actions and words don’t lead to “Summertime Sadness”.
Over the past few decades, we have been used to central bankers stepping in when all the good times seem to have gone. However, given the level of inflation it seems that they no longer want to go on like that. Following a pandemic and an acute energy crisis, when all we could do is sing "Sad Songs”, it seems that the tune of consumers has shifted to “Crocodile Rock”. The debate is whether monetary policy has lost its potency. By moving interest rates higher, the expectation is that behaviour shifts from borrowing to saving, thus cooling the economy.
However, with inflation and the labour markets still seeming to behave like a "Runaway Train”, central bankers now see the risk of doing too little as lower than doing too much. As such, they are prepared to risk a recession by raising rates further still. While the conversation at Sintra this week was a belief they could engineer a soft landing, the broader tone from Fed Chair Powell, ECB President Lagarde and Bank of England Governor Bailey, was one of trying to emphasise price stability over anything. Having inflation run for so long above target is not particularly desirable for those trying to achieve their mandate of stable prices over the medium term.
Given central bankers are now emulating the hawkish stance of central banking in the 1980’s, they re-affirmed that their response function is not to stimulate demand but to ensure balance between supply and demand. In essence, developed market central banks are saying that they might not be there to “Save My Life Tonight”. Given the lags that monetary policy operates with, notwithstanding its potentially more muted effects on demand side, they risk larger financial side-effects by adopting this strategy.
Whilst we hope they turn out to be "Pinball Wizards” and manage to steer the economy back toward price stability without too much collateral damage, the prior decade was marked by a low level of defaults, aided by the low level of interest rates. As we become accustomed again to an environment with more normalised interest rates, we should expect a higher level of defaults over time. This boom-and-bust cycle that was prevalent throughout most of the 20th century looks set to be more common again, a virtuous “Circle of Life”. In time this may result in productivity benefits but that could be a painful adjustment.
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