Central Banks Will Rather Have Recession Over Inflation

Despite the fact that December has arrived, central banks’ balance sheets have hardly, if at all, shrunk. A weaker currency and the price of accumulating bonds, rather than genuine sales, account for the majority of the reduction in the major central banks’ balance sheets.

Investors must consider the risk of a major drop in central bank balance sheets in the context of government deficits that are hardly falling and, in some cases, expanding. Both central banks’ quantitative tightening and the refinancing of government deficits, albeit at higher costs, will drain liquidity from markets. As a result, the global liquidity spectrum contracts significantly more than the headline figure.

In the transmission mechanism of monetary policy, liquidity drains have a dividing impact, but liquidity injections have a clear multiplier effect. In the transmission mechanism, a central bank’s balance sheet expanded by one unit of currency in assets multiplies at least five times. Calculate your exit strategy today, but keep in mind that government spending will be financed.

We have the propensity to take money for granted. Over the years of monetary expansion, investors have increased their risk and acquired illiquid assets due to the FOMO (fear of missing out) mentality. Multiple expansion and rising valuations are the norms during periods of monetary excess.

Because we could always bank on increased liquidity, when asset values fell over the last two decades, the ideal strategy was to “buy the dip” and double down. This was because central banks would continue to expand their balance sheets and add liquidity, rescuing us from practically any bad investment decision while keeping inflation low.

20 years of a risky bet: monetary expansion without inflation. How do we deal with a situation in which central banks must remove at least $5 trillion from their balance sheets? Do not trust me when I say that the $20 trillion bubble created since 2008 cannot be resolved with $5 trillion. A $5 trillion tightening in US dollars is considered modest, even dovish. To go back to pre-2020 levels, the Fed would have to reduce its balance sheet by that amount.

Keep in mind that the developed economies’ central banks need to tighten monetary policy by $5 trillion, which is on top of the $2.50 trillion of public deficit financing in the same countries.

Advertisement

Contraction’s impacts are difficult to predict because merchants have only known expansionary policies for at least two generations, but they are undeniably unpleasant. Liquidity is already diminishing in the riskiest areas of the economy, from high yield to crypto assets. By 2023, when the real tightening begins, it will very likely have reached the ostensibly safer assets.

In a recent interview, Bundesbank President Joachim Nagel stated that the ECB will begin to reduce its balance sheet in 2023, and that “a recession may be inadequate to return inflation to target.” This implies that the “anti-fragmentation instrument” now used to hide risk in periphery bonds may start to lose its placebo effect on national assets. Furthermore, if sovereign bond spreads rise, so does the cost of equity and the weighted average cost of capital.

Capital can only be created or destroyed; it is never constant. And capital destruction is unavoidable if central banks are to effectively combat inflation.

The common bullish claim is that having learned from 2008, central banks will not dare to allow the market to crash. Although accurate, it is insufficient to warrant market multiples. What matters to central banks is that governments continue to finance themselves, which they will. Government spending squeezing out private sector credit availability has never been a key worry for a central bank. Remember that I am just estimating a $5 trillion unwind, which is extremely generous given the surplus produced between 2008 and 2021, as well as the extent of the balance sheet expansion in 2020-21.

Central banks are also cognizant of the worst-case scenario, which is high inflation and a recession that might have a long-term impact on residents, resulting in increased discontent and widespread poverty. They understand that they cannot maintain inflation high in order to meet market expectations of growing valuations. The same central banks who claim that the wealth impact multiplies are well aware of the devastating repercussions of neglecting inflation. Return to the 1970s.

The “energy excuse” in inflation forecasts will almost certainly vanish, and this will be the key test for central banks. Since June, the “supply chain explanation” has vanished, the “temporary excuse” has become stale, and the “energy excuse” has lost some credibility. The latest commodity slump has exposed the unappealing reality of rising core and super-core inflation.

Central banks cannot accept continuous inflation since it would imply that they have failed in their mission. Few can predict how quantitative tightening will affect asset values and credit availability, despite the fact that it is necessary. What we do know is that quantitative tightening, with only a minor reduction in central bank balance sheets, is projected to compress risky asset multiples and values more than it has thus far. Given that capital destruction appears to be only getting started, the dividing effect is likely to be more than expected. And capital destruction always has an influence on the real economy.

For More Economic News, Click Here.

Advertisement