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Times op-ed: Geopolitical risk and the end of cheap money is the new normal

Feb 19, 2024

This op-ed was first published in The Times – 19 February 2024.

What is the new normal? Globally, financial markets are coming to terms with a new geopolitical, economic and policy landscape. The most dramatic change is geopolitical uncertainty and the risk of a further-splintering world order. Many possible paths exist, and the multiple elections this year add to these.

One necessity is increased defence spending, particularly in western Europe. How this can be accommodated with debt levels that are already high remains to be seen. Another geopolitical consequence is bouts of market volatility and increased risk premium in energy prices when tensions rise.

In terms of economic outcomes, last year confirmed a shift from globalisation towards fragmentation. Firms replaced cost-control with security and risk concerns in making global decisions. Friendshoring and onshoring has been the result. The shift is towards partial protectionism, with more countries following America’s lead towards industrial policies. Meanwhile, in China, a legacy of the trade tensions from Donald Trump’s presidency has been a shift towards self-sufficiency in food, fuel and technology. Chinese supply chains across east Asia are also expanding.

Alongside fragmentation, western economies have shown remarkable resilience in their jobs market. It has been a job-friendly downturn.

Overall, we appear to be heading for a disinflationary environment, with modest global growth. As inflation falls, this will allow financial conditions to ease and will provide a boost to real incomes.

Thankfully, the two factors that triggered the global surge in inflation have been reversed, namely previously lax monetary policy in the west and supply-side problems after the pandemic and the war in Ukraine. Yet it is still unclear where inflation will settle globally. There are certain factors that are more inflationary than before the pandemic, namely fragmentation and the rising share of wages, although much depends upon productivity. Some companies are also using their market power to boost their margins. Workers and firms have more pricing power across many western economies than previously, although mitigated still by technological change. In Britain for instance, inflation looks set to undershoot its 2 per cent target by this summer, before rising slightly.

That leads to the issue that markets are already focusing on: where in this new landscape will interest rates settle? Rates must fall, but when and by how much? The danger in the UK is a pyrrhic victory over inflation, with the economy very weak if monetary policy stays too tight.

It is not only interest rates, but also the pace at which the Bank of England shrinks its balance sheet by selling gilts to reverse quantitative easing. This will leave the taxpayer with a huge bill as the Bank sells gilts at a loss and it will keep yields and thus borrowing costs across the economy higher than they need be.

Although UK policy rates rose too far last year, it seems unlikely that they will be cut imminently. With services sector inflation edging up to 6.5 per cent in January and wage growth above 6 per cent, the Bank will keep rates on hold. While the US Federal Reserve has a dual mandate on jobs and inflation, the Bank’s sole inflation target may lead to a bias to keep rates too high. Incredibly, two of the nine monetary policy committee members still want to hike.

Monetary policy should be forward-looking as it may take more than 12 months for policy changes to feed through fully. Yet in Britain it is now coincident, driven by the latest economic data.

Ahead of the pandemic, central banks in western economies accepted that rates would be low for long and thought that this could continue. This fed inflation. Their counterparts across emerging economies were more prudent, so much so that the present easing in global monetary policy is led by Chile, Brazil and China, with others joining in, too.

Markets wonder what to take from r*, or r-star. This is the neutral level of real, or inflation-adjusted, policy rates. While it did not determine policy, central banks were keen to cite it when rates previously were low. Before the pandemic, r-star was seen as being close to zero in the United States, Britain, the euro area and Japan. In the US, recent estimates now put it higher, but still at low levels. It is a similar story here. The trouble is that r-star is unobservable and is a theoretical concept. Many factors have led to a low r-star, such as weak trend growth and demographics. While these structural factors have not changed, the markets are now mindful of the problems caused by cheap money polices. The reality is that a focus on a low r-star may lead monetary policy astray, a point made previously by the Bank for International Settlements.

Here in the UK, low rates fed financial instability as markets did not price properly for risk. Cheap money contributed to a misallocation of capital and so did not help productivity to recover. It also fed asset prices inflation and greater wealth and inter-generational inequality, as well as contributing to inflation.

We shouldn’t rely on monetary policy to be the shock absorber for the economy in the way it has been since the 2008 financial crisis. Ideally, more heavy lifting should be done by other policy levers, whether fiscal, regulatory or macro-prudential. To facilitate growth, there are many levers that can be pulled, but they are not always politically feasible. For example, implementing credible and ambitious planning reform to build more homes and business sites.

Given this, the danger is that pressure will mount for interest rates to fall too far. The market expects UK rates to fall from 5.25 per cent to 4.5 per cent by the year’s end. This seems a fair assumption. Rates may settle subsequently at about 4 per cent, in line with the growth in money GDP.

There is a need to avoid rates returning to previous lows, but this should not prevent necessary easing in monetary policy as the year progresses.