In the end, it is all about containing Inflation
Today world’s economy is under tremendous pressure. The reasons are — a) supply chain disruptions due to the lockdown; b) excessive liquidity especially in developed markets due to free cash dolled out at the time of the lockdown; c) rising energy prices driven by the Russia — Ukraine war.
These three factors have contributed to demand and supply mismatch — driving inflation to a magnitude that we haven’t seen for a long time in the past.
The central banks all over the world look desperate. Now, with the cat out of the bag, the action of the central banks to raise rates is analogous to administering chemotherapy to a patient suffering from uncontrolled cell growth (cancer). The purpose of raising interest rates is the make loans costly so that “inflation” can get contained by pulling the economy down (i.e by forcing the economy into a recession). No one can be sure of the time it will take to cure and the damage it will cause to the economy as a consequence of this curing process. More so because, the sickness is not limited to just a few pockets, but has spread everywhere in this connected world.
Dangers
If actual inflation doesn’t get contained in time, then the public’s perception of “expected inflation” will increase and this will raise long-term yields of bonds (no one will like to buy a bond at a lesser rate than his long-term perception of expected inflation). Rising bond rates will make long-term debt costly and increase the government’s outflows on interest payments, as a bulk of these long-term debts are held by the government.
Rising “expected inflation” has the danger of fueling actual inflation further as businesses in anticipation will raise the prices of their products and services and workers will demand higher wages.
These proactive actions taken by citizens in anticipation of an “expected inflation” will cascade and disturb the balance of our overall economic system, thereby making it much harder to cure.
Damages
If this disease is left uncured, then the damages can be severe and long-term. a) Real GDP growth of the economy will get affected — resulting in lesser opportunities for employment and a decrease in overall prosperity; b) Value of currencies will alter negatively — the stronger will become more powerful and the weaker will get vanquished; c) Smaller nations will face a huge BOP crisis, resulting in huge suffering and crisis; d) Asset prices will get impacted due to rising fear and the risk-free rate (10-year bond rates used as one of the components for calculating valuation); e) Government’s all over the world will have to take more debt to pay for meeting day to day expenditure and funding projects; f) This increased debt will raise the Government’s interest payment obligation and can have a spiraling impact.
Hence, one can now appreciate the urgency of the central banks all over the world to make all attempts to cure the problem in a short window of time. The more the problem is stretched, the more difficult it will get to cure — largerly on account of change in public perception of “expected inflation” for the future.
Finally
The change in public perception of “expected inflation” can be easily measured by looking at the 10-year bond rates — which are already in the rising trend all over the world. Hence, in the end, it is all about managing inflation and preventing it from going out of control. And let’s all hope we succeed in our objective.
(This is only a concept note, and for simplicity, I have deliberately kept the financial numbers out to prevent unnecessary distractions)
