Let’s rewind the clock. We are in the midst of the Financial crisis in 2008 and the world economy is collapsing. Homeowners are evicted when debt payments are not serviced, the stock market plummets, effectively diminishing the savings of ordinary people, and millions lose their jobs as the economy delves into the deepest recession since the Great Depression in the 1930s.
So how are the central banks going to get a grip on the indebted economy and reverse course?
To simplify, central banks set the monetary policy, which consists of two elements: interest rates and the money supply. These policy tools have historically been used in shorter periods to stimulate the economy, but during 2008 and 2009 the Federal Reserve (Fed) began the largest economic experiment seen in modern times.
Firstly, the Fed lowered interest rates to zero, where they remained for seven years, in order to stimulate the economy. Keeping interest rates at zero puts central banks in a stranglehold, as they cannot lower interest rates further if the economy is to spiral into recession. Previously, short-term interest rates had only touched the zero mark for shorter periods, making this unconventional monetary policy truly unprecedented.
Secondly, the Fed started an unparalleled purchasing spree using quantitative easing (QE) to buy securities and bonds.
Economists say that growth is a product of the money supply and the velocity of money (the rate at which money is exchanged in an economy). Therefore, when the velocity of money drops in times of a recession, central banks can increase the money supply to stimulate the economy. Quantitative easing is a tool to increase the money supply by buying bonds and long-term treasuries, providing liquidity to the market.
Between 1913 and 2008, the Fed gradually increased the money supply from zero to $900 billion, a gradual increase producing mild economic stimulus throughout the 20th century. Fast-forward to 2008, a desperate Federal Reserve is facing the largest recession in 100 years. Inspired by Japan's recent success with QE, the Fed prints $3.000 billion between 2008 and 2014, equivalent to 300 years' worth of money printing in under 6 years.
Instead of facing the music, the central banks tried to hire more musicians for the orchestra, as if playing louder would drown the underlying melody. Every time the central banks tried to reverse course and raise interest rates, they did not have the nerve or guts to endure the inevitable crash of the economy.
We got a glimpse of this dilemma in 2018 when the Fed tried to tighten its expansionary policy. A slow but steady increase in interest rates, and a withdrawal of QE resulted in a rapid economic downturn in 2018, leading to the Fed abruptly calling off the tightening at the start of 2019, now referred to as the Powell pivot.
The stimulating effects of QE and a low-interest-rate environment created two shaky pillars under the economy, synthetically pumping securities and distorting the risk associated. Effectively creating the everything bubble, where prices are driven by easy money instead of the fundamentals of stocks and securities. As the central banks buy bonds through QE, the yield is squeezed, pushing investors into riskier assets and making the market more vulnerable to external shocks.
Inflation will pop the everything bubble
Fast-forward to March 2020. The pandemic struck the world and the stock market contracted over 30% in a matter of days as a result of the increased uncertainty, ending the longest bull run in history beginning in 2009.
The solution from the Fed?
The central banks doubled down on their economic experiment and started an even larger open-market operation to inject liquidity into the market. Interest rates that in 2019 had climbed incrementally up from zero, as the Fed tried to tighten policy, got slashed to zero.
Since January 2020, the Fed has printed almost $2.800 billion new dollars, meaning 40% of US dollars, in existence today, have been printed since January 2020. The previously unprecedented money printing between 2008 and 2014 has now been surpassed by the post-Covid economic relief. In fact, the same amount of money that was printed in the six years following the financial crisis has now been pumped into the economy in less than 24 months.
Besides the monetary stimulus, governments started handing out money through fiscal policy using stimulus checks and tax breaks to encourage spending. Unsurprisingly, two years later, inflation is at a 40-year-high and the economic engine is overheating.
Will the stagflation of the 1970s return?
Many economists have drawn parallels between the current situation and the stagflation of the 1970s. The 1970s were characterized by high inflation, expansionary monetary and fiscal policy, and rising energy prices resulting in stagflation - the toxic combination of slowing economic growth and high inflation.
Today, inflation has reached a 40-year-high as a result of excess demand given monetary and fiscal stimulus, and supply-chain bottlenecks causing shortages and lower capacity. The monetary and fiscal policy has been expansionary for a decade, and energy prices are rising as a result of the current war in Ukraine. This does look a lot like the 1970s.
So are we entering a prolonged period of high inflation?
The persistently high inflation of the 1970s was largely the result of the central banks' inability to act. Draconian measures were needed to tame high inflation and when the Fed rapidly raised interest rates, it led to a severe recession in 1982. Unlike in the 1970s, central banks today have inflation targets, forcing them to act rather than turn a blind eye.
I would argue that the worry of a recession is far more legitimate than the worry of long-term inflation. For the next short to medium term, we will likely see high inflation, but the Fed will definitely not allow prolonged high inflation. In early 2022 as inflation rose sharply, the Fed, for the first time since 2018, warned of new rate hikes, showing that they are serious about taming inflation.
The risk thus lies in the ability of central banks to raise interest rates and withdraw QE, at a rate that both deleverages the economy and does not cause a recession. A balancing act that history has shown is almost impossible to pull off.