in the play by JM Barrie Peter Pan, the audience is encouraged to clap if they believe in fairies. If they don’t clap, the character Tinkerbell the Fairy dies. The Tinkerbell phenomenon only exists because people believe in it.
Central banks in developed countries are experiencing such a moment. For 30 years he has been a key player in economic policy, regulating the cycle through interest rate adjustments and quantitative easing. Central bank primacy coincides with an era of low inflation; Clear proof of their political competence.
And investors also have faith in central banks’ ability to bail out the economy in times of stress. When central banks signal that they are about to ease monetary policy, stock markets tend to rally. Under Alan Greenspan, long-time Federal Reserve Chairman, the phenomenon was known as the “Greenspan Put.”
But now the expertise of the central banks is being questioned. They have been swept up in the inflation spike over the last 12 months and have been slow to raise interest rates to counteract it.
In fairness, high energy prices coupled with Russia’s invasion of Ukraine were a major factor in the rise in inflation. Bank of England Governor Andrew Bailey told the House of Commons the central bank had suffered an “almost unprecedented” series of shocks. But he added that “it’s extremely difficult to predict inflation at 10 percent and say there’s not much we can do about it.”
This admission of impotence is quite strange. If central banks don’t deserve the blame for the recent inflation boom, they probably don’t deserve credit for the weak inflation of the past three decades.
Low inflation was fueled by China’s entry into the global economy, a move that flooded the developed world with cheap goods. Technological changes that reduced business costs also played a role. Maybe central banks weren’t really brilliant economic managers – maybe they were just lucky.
Another problem with Mr. Bailey’s admission is central banks’ ability to manage expectations. When companies believe that central banks can control inflation, they avoid passing increased costs on to consumers as higher prices; If workers believe central banks can control inflation, they will not demand higher wages to compensate for higher prices. But if they lose faith in the banks, it will become free for everyone like it used to be in the 1970s. Tinkerbell was stone dead at the time.
This measure has yet to erode confidence in central banks. On the futures market it is possible to forecast long-term inflation expectations. This indicator shows that investors only expect an inflation rate of 2.1 percent in the five years after 2027.
But the surge in inflation was a heavy blow to the bond market. 10-year government bond yields, from just 0.54 percent in March 2020, rose to 3.43 percent in June, the highest level in more than a decade.
The 10-year bond yield has since fallen to 3 percent. Recent volatility suggests investors are now uncertain about how well the Fed can manage the business cycle. Recent data has been deceptively showing that the labor market is still healthy, but consumer confidence has waned and manufacturing is still struggling.
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But perhaps the greatest test of confidence in central banks is taking place in the stock markets. In June, the S&P 500 met the technical definition of a bear market when it fell more than 20 percent from its January highs.
In the past, investors would have expected a little help from the Fed in the form of rate cuts. Instead, just days later, the Fed announced its largest rate hike since 1994, rising by three-quarters of a percent.
Of course, central banks would ensure that a “Fed put” would never be a deliberate policy. When they lowered interest rates in the face of market turmoil, they were trying not to prop up asset prices, but to cushion the potential economic damage that would come with a financial meltdown. Now that inflation has returned, central banks can no longer afford to worry about financial markets – they just need to curb price pressures.
Instead of playing the role of Tinkerbell, the Fed has become the alligator in Peter Pan, relentlessly chasing Captain Hook. Investors used to think central banks would bail them out – now they fear banks might bury them.
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