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Paying a heavy price for central banks’ money creation

Much of the damage to bond and stock prices that we expected this year has been done. Markets are quickly adapting to a new world of higher inflation in most advanced countries. They are getting used to having to raise interest rates to counteract price increases by slowing economies.

The markets were ruled by the leading central banks. Studying it has been critical to being able to see into the future for economies and financial assets.

Asian markets have been led by China and Japan, which managed inflation well, keeping it at around 2.5 percent despite large increases in energy and food costs. Both also exercised reasonable control over their money supply and credit during the Covid lockdowns, with the People’s Bank of China maintaining its money target.

By contrast, the leading Western central banks – the Federal Reserve, the European Central Bank and the Bank of England – did not focus on money and credit and were not concerned about money and credit, while actively promoting major expansion to mitigate the impact of lockdowns and supply chain interruptions on general activity. Each of them continued money creation well into the recovery, ending in double-digit inflation.

The Fed has given the biggest boost to its economy and has decided to end all money creation starting in the second quarter of this year, reduce its inflated balance sheet and aggressively raise interest rates from ultra-low levels to demonstrate its determination to curb inflation. to row. This has led to a sharp sell-off in bonds and many stocks, especially the growth successes of the long bull market.

The Bank of England was the first to end money creation, stopping it in December last year. Now trying to balance the need for higher rates to tackle inflation and the risk of it turning so strong that it triggers a recession next year, on Thursday it chose to cut its key interest rate by 0.5 percentage points. to increase.

However, the central bank with by far the biggest headaches is the ECB.

I’ve kept the FT fund out of continental stocks for several reasons, except for a small, indirect exposure from holding the world index. The EU’s economy faces an energy shortage, made worse by Russia’s violent invasion of Ukraine and the need to get Russian energy from Europe’s supply sources.

It has been more directly damaged by the war and sanctions than the US. In terms of climate change, it has embarked on a vigorous net-zero path, meaning many of its more traditional industries need to be closed or modified.

The euro area is still divided between those with a surplus that generate more euros from trade and economic success, and those with a currency deficit and need to borrow more. The original euro arrangement had strong Germanic elements. Each Member State had to control its own budget deficit and was responsible for its own loans. The central bank should not assist Member States in financing excessive deficits. Countries with a deficit had to cut spending or increase taxes.

Today, there are many who want to relax these strict rules. The need to keep government deficits to 3 percent and public debt to 60 percent of GDP has been suspended. Germany’s surpluses and some others are deposited with the ECB, which lends them to deficit countries at zero interest rates to ensure smooth settlement within the zone.

The ECB is debating how to ensure that its policies are implemented across the region. This is fancy talk to try to keep borrowing rates lower on longer and shorter term loans at comparable interest rates across all member states.

The ECB sets the same short-term interest rate for the entire zone, but it does not set the rates at which individuals and companies can borrow from commercial banks in different countries, and it cannot determine the rates states must pay to cover their own bills by spending longer. borrow time.

It is concerned about how Italy’s borrowing costs are far above Germany’s. It wants to prevent the heavily indebted Italian state from having to pay too much for new loans and getting into financial trouble with its high interest accounts.

In the two decades that Italy has been in the euro, it has failed to reduce its public debt and remains well above the required figure. The EU is now trying to help Italy by sending much of the EU’s central recovery funds to reduce the need for Italy to borrow itself. These funds are collected as EU debt.

The ECB continued to create money and buy bonds until the end of June, before ending its bond-buying programs. There are now five countries in the zone with inflation rates above 10 percent.

However, it is concerned about the current sluggish performance of many of the national economies, and wants to be able to buy the bonds of the deficit-ridden countries to prevent their rates from becoming too high. This will likely prolong the political muddle to accomplish the nearly impossible task of preventing a recession, stopping inflation and maintaining bond yields.

I continue to look for ways to get better returns on the significant cash the fund has managed as markets recognize more of the tensions to come.

Sir John Redwood is global chief strategist for Charles Stanley. The FT Fund is a dummy portfolio designed to demonstrate how investors can use a wide variety of ETFs to gain exposure to global equity markets while keeping investment costs low. john.redwood@ft.com

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