It appears that the world’s central banks no longer consider inflation to be the most significant risk to the global financial system. Managing price stability, previously the core remit for any central bank, is now relegated behind the tasks of supporting growth and establishing financial stability.
Following the extraordinary steps taken by the US and UK central banks in response to the on-going credit crisis even the conservative European Central Bank (ECB), under its president Mario Draghi, has explicitly stated it will do whatever it takes to preserve the euro. Although the bank has yet to act on these words, it is clear that its once steadfast priorities are now fundamentally changing.
Before the credit crisis broke, there was an expectation that inflation would remain steady. This was amply illustrated by flat inflation breakeven and inflation swap curves in leading issuing countries. Central banks still had strong anti-inflationary credibility and inflation expectations were identical at the short end as well as at the long end, hence the flat curves. The priority of central banks was price stability and all monetary policy instruments were tailored to this end.
However, it becomes clear that the financial crisis has noticeably upset central banks’ hierarchy of priorities. The most extreme case can be seen with the ECB, which Draghi has strongly hinted will play an increasingly central role in tempering Italian and Spanish government bond yields. The ECB is expected to purchase large quantities of these countries’ debt in the secondary market, in order to reduce their interest rates. Such extraordinary interventions can be excused, according to Draghi, because interest rates that are too high in Italy and Spain hamper the functioning of the monetary policy transmission channels. While this behaviour is far removed from the ECB’s remit to guarantee price stability, in order to preserve appearances price stability continues to be presented as central to the conduct of monetary policy.
In practice, the objective of managing inflation has taken a back seat to other more pressing issues, such as supporting economic growth and establishing financial stability – two things in acute shortage today in the eurozone. Indeed some of the instruments being used to stimulate growth or guarantee financial stability, for example quantitative easing (QE) and, more generally, the balance sheet policies of the central banks, are well-known to be inflationary. The bank argues these measures are taken in response to extraordinary circumstances, even though the results of such actions are counterintuitive to price stability.
In the short term, of course, inflationary risk today is slight. Indeed in some countries, including a number of eurozone peripheral countries, it is the deflationary risk that is most pressing. Real interest rates are high, unemployment figures have risen to record levels, real salaries are eroding, and production is declining; all of which are deflationary forces.
There are also objective reasons why central banks are not overly worried about inflation. In most countries across the world, inflation has fallen back to low levels and in our view it is likely to continue its trend downwards. In the US, for instance, the rate has fallen back from 3.6% a year ago to just 1.7%. In the UK, it towered at more than 5% last year, but now sits at only 2.4%. And although there was a rebound in crude oil prices in July, these remain far below the levels reached in February and March.
Credibility at Risk
As a result, the inflationary risk, triggered by ECB actions, is concentrated over the medium to long term, with its crystallisation likely to result from the closure of output gaps, an increase in raw material prices, or an overly slow normalisation of monetary policies.
Any shorter-term inflationary risks, for instance stemming from rising agricultural commodity prices which have returned to 2008 levels, are likely to be hampered by central banks’ focus on growth and financial stability.
Which poses the key question: how much longer will central banks pursue non-conventional monetary policies that are designed to meet these new ends?
Much would depend on the country or the region, of course, because the problems that confront central banks are never the same. In the eurozone, the ECB could soon reactivate its securities market programme (SMP) and purchase significant amounts of peripheral government debt in an attempt to guarantee ceiling interest rates. If this strategy was for the long haul, perhaps with help from the European Financial Stability Facility and the European Stability Mechanism (EFSF/ESM) in making purchases in the primary markets, the central bank’s balance sheet will continue to balloon, further stoking any pent-up inflation expectations. In the US the Federal Reserve might well engage in another round of QE, with the sole objective of stimulating economic activity.
Indeed, a clear sign that central banks have undermined their anti-inflationary credibility can be seen in today’s inflation swap or inflation break even curves. They are now steep for the US and the eurozone. Fixed income investors for these regions have factored in a significant increase in long-term rates of inflation.
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