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The following is an expression of my views. It is not a proper economic analysis. At best, it is an informed opinion.

Since mid-Q2 2021, inflation has definitely stolen the award of most trending topic among economic policymakers and market participants and observers all over the globe. As a consequence, during summer or early in the fall, many emerging markets central banks initiated a monetary tightening, and the Fed and BoE are heading toward a normalization path. In this brief note, we will look at the main dynamics guiding central banks’ policies globally, the prospects of soon-to-begin tightening of the Fed, and the justifications of ECB’s usual latency.

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Monetary policy 101: keep calm and be a central banker

When it comes to central banking, the rulebook is quite straightforward since the advent of monetarism and the doctrine of central bank independence. The mandate is clear: price stability, plus the level of economic activity, usually through unemployment rate monitoring, when legislators allowed for less conservatism as it is the case in the US.

The main policy has been and still is the interest rate: when prices rise and economy overheat, central bank act hawkish and raise rate, when the economy is going through a crisis or/and prices are threatened by deflation, it takes a dovish course of action and lower rates.

An addendum to the rulebook was issued during the great financial crisis, when monetary policymakers got stuck in the so-called zero-lower-bound situation and were forced to venture in unconventional endeavours. Central banks launched the now famous quantitative easing operations, i.e., the purchase of public and/or corporate bonds on the secondary market to further ease financing conditions.

Covid-19: when central bankers became firefighters after playing resuscitators for over a decade

For the past decade, major central banks in the developed world were at the forefront of the fight for recovery, and in the EU, against deflationary pressures, while the fiscal arms were missing due to, first, a now invalidated austerity doctrine, and second, a very high indebtedness level on the aftermath of financial systems rescues. Following the 2016 words of the renowned economist Jeffrey D. Sachs: “Central banks and hedge funds cannot produce long-term economic growth and financial stability. Only long-term investments, both public and private, can lift the world economy out of its current instability and slow growth”. Yet, central banks kept playing growth resuscitators and deflation crusaders for over a decade.

When the primarily symmetric shock of Covid arose, central banks played another card from their deck; the firefighter one. For many observers, “the scope and speed of the international central bank policy response to COVID-19 has met or often exceeded that of the 2007-2009 crisis”. The sell-out of risky assets provoked a turmoil on a financial markets and threatened to harden financing conditions with the spectrum of transmission to an already dragged real economy.  

The Fed lowered its key policy rate by 150 bps successively in March and April. Most emerging markets’ central banks followed suit. The BoE reacted accordingly, bringing its key rate down from 0.75% to 0.10%. The ECB kept it rates unchanged as they were already in the zero range. However, quite swiftly, central banks resorted to the addendum. The ECB progressively augmented its purchasing commitments as part of the Pandemic Emergency Purchase Programme (PEPP) to a total of 1 850 billion EUR. The BoE also initiated an Asset Purchase Facility of the size of 875 billion GBP. Finally, the Fed launched six different purchase programs and credit facilities, amounting to 1 310 billion USD, plus unlimited purchases of agency MBS and Treasuries.

Additionally, no less than 13 central banks of emerging markets inaugurated their own asset purchasing programmes, with amounts, when communicated, reaching the levels of 2.8% of GDP, in the case of Chili. Among those countries are Hungary, Poland, India, Thailand or even South Africa.

If QE operations are good game savers in times of crisis, their unwinding is a veritable conundrum for policy makers. Fears are high that the end of such measures will upend financial markets, like in 2013 and the taper tantrum, as it is believed that the high level of assets’ prices is primarily due to the belief of long lastingly low long term bonds rates. Central bankers are entangled with the QE, yet what really matters to markets right know is more the prospects of rising interest rates than the possibilities of a tapering.

A bold and fierce bet: investors vs. policymakers

In the years following the great financial crisis, monetary policymakers showcased a lot of ingenuity expanding their toolset. One of the tools was coined as the forward guidance, i.e., the communication of the evolution course of interest rates in the near-to-medium term. Forward guidance of most central banks pointed to the maintenance of low rates up until the end of 2022-2023. Record breaking inflation rates are leading markets to question such commitments. Bank of Australia and Bank of Canada already gave in to market pressure, the first ditching its yield-curve control policy early November, and the second announcing the end of its bond-buying scheme late October. Markets movements are similar in the UK, the US and the EU, bonds yields breaking some records, even though central bankers there seem to hold to their dovish stance, so far.

Why do markets pressure the yield curve? The response is quite straightforward, the macroeconomic global outlook. Energy prices are on the rise, and the same goes for commodities. Pent-up demand is putting pressure on supply chains and producers, creating a mismatch that is so far believed as transitory, but for how long will the transition last? Central banks consider current inflation figures as the peak and envision a return to targets as early as in 2023. Markets also look at the labour market, where workers seem to gain bargaining power, prompting future wage rises and inflation. However, long term interest rates are still stable, which indicates that markets, to this date, buy in the transient story of policymakers.

The inevitable tapering: how to do it right?

If long term market outlook is reassuring for policymakers, it does not mean that the question of tightening should be eluded. Before talking about raising rates, central bankers are facing the question of QE tapering. Again, as mentioned earlier, the 2013 episode makes it a step to take with high caution for central bankers. But the caution must not transform in fear. Many observers review the taper tantrum under the prism of signalling. Ben Bernanke then declarations were understood by the market as a shift to a hawkish stance that will ultimately lead to rates raises, which it did. Yet, it appears that markets do not react much to tapering, but rather to raising rates. If forward guidance is bold enough to sever the ties between tapering and rates policy, an unwinding of QE without much fuss becomes very likely. Rates setting policy will then be independently determined and mainly centered about the question of the transitory component of inflation rise.

The ECB: a justified latency?

As markets are used to since the famous words of super Mario Draghi in 2012, the ECB appears to remain firmly fixed at the dovish extreme of global central banking landscape. This stance might be explained by an implicit task of the monetary zone’s central bank: the maintenance of favourable financing conditions for all euro zone’s members, hence keeping sovereign bonds spreads moderately low.

As inflation soars, the ECB was very careful to avoid a confusion in markets interpreting the rise in the price index as a signal of future monetary tightening. Chief economist P. Lane laid down the conditions for a tightening; first, inflation must attain the 2% target way ahead of the projection horizon of the bank, second, this level must be sustained until the end of the projection period, and finally, core inflation progresses must be sufficiently advanced to be consistent with a medium-term stabilisation of inflation at its target.

The thorough communication strategy is enlightening regarding the inflationary shock that is now characterizing the global economy. It gives clear arguments justifying the dovish stance of major central banks worldwide. In the short term, inflation can have negative macroeconomic implications, namely downward pressures exerted on core inflation by fading growth prospects and negative wealth effects caused by the degradation of the terms of trade. Additionally, if the pandemic causes an inflationary surge in the short run, it also impacts durably behaviours that might have deflationary effects. Digital transformation and energy transition might bring efficiency gains pressuring down inflation. A new collective view of work and arbitrages between paid work and leisure time can also have a lasting a sobriety-induced deflationary impact.

Imminent tapering, wait and see for the tightening…

As a conclusion, this broad review in the world of central banking might indicates two trends. A most likely tapering that will carefully take place while severing the ties between asset purchasing programmes and rate-setting policies in markets expectations and a lasting uncertainty regarding the implications of the so far transitory inflationary wave that is crossing the world economy. In few words, tapering is very likely in the short term, rates rises are very uncertain.