Let me explain how central banks will change with the war

In wartime history, there has never been a central bank that has prioritized price stability and it won't be this time either. The analysis by Alessandro Fugnoli, chief strategist of the Kairos funds

Why do central banks exist? At the end of the seventeenth century in England and shortly thereafter in France the Bank of England and the Banque Générale (ancestor of the Banque de France) were established to finance the new military expenses of the sovereign (in England) or to facilitate the disposal of the war debt incurred. by the Sun King in previous decades.

The Federal Reserve was created in 1913 with a different goal. The sovereign's accounts were in order, but the financial crisis of 1907 had highlighted the fragility of the big banks. A wave of bankruptcies had then been averted by the intervention of the banker John Pierpont Morgan, but it was understood that it was better, in the future, to institutionalize the role of savior of last resort of the system by establishing a central bank.

In the latter part of the twentieth century and in the first two decades of our century, two generations of economics students (including all future central bankers) were educated to think that the main function of central banks was yet another, namely that of controlling inflation. Of course, in some countries this role was accompanied by another one of maximizing employment, but even in these cases, price stability remained the primary goal of equality.

With the pandemic, a historical phase began in which the main function of central banks changed again. In this new phase, the three objectives that characterized monetary policy in the various previous historical phases take on prominence, namely to facilitate the sovereign (by monetizing the deficit and keeping its cost low with financial repression), to save the financial system (as was done in the 2020) and bring growth back to its potential. Price stability has become the ultimate goal of equals.

The exception, in this new course, is Asia. In the last 12 months, prices in China have risen by only 1.8 percent, in Japan by 0.5 (with core inflation even falling) and in the rest of East Asia they have remained close to 2 percent everywhere. Inflation will also remain under control for the foreseeable future. The reason is that in Asia, on the one hand, fiscal policies have been much less expansive, while on the other wage inflation has been conspicuous by its total absence.

In America and Europe we are witnessing the efforts of the Fed and the ECB to recover credibility on inflation. Credibility is important to save what remains of the anchoring of inflation expectations. If the anchor were to break completely, we would all try to index prices and wages and control could then only be re-established through a painful recession.

In recent days, in an effort to raise the bar for anti-inflationary rhetoric, Powell has declared his admiration for Paul Volcker. Volcker's greatness, the one for which he was later sanctified, was to dramatically raise rates between 1980 and 1982, cause two recessions one after the other and endure two years of very harsh criticism from business and finance...

We can be sure that Powell will not have the determination to go through with fighting inflation like Volcker did and will stop much sooner. The rate hike cycle and Quantitative tightening will start fast, but the accumulated lag is large. On the other hand, the Fed will stop as soon as it sees a recession looming on the horizon. Today, with an overheated US economy and labor market, it is easy to be (or pretend to be) aggressive, next year it will be much more difficult.

The result is that inflation will remain well above official targets for as long as foreseeable. In wartime history, there has never been a central bank that has prioritized price stability and it won't be this time either.

The argument is all the more true for the ECB, which has in fact abandoned the goal of bringing inflation under control and limits itself to buying time, counting on the fact that the price tensions will fade by themselves.

There are certainly valid reasons that explain the attitude of central banks (the errors are upstream and date back to an ultra-expansive 2021 with an overheated US economy) and it will be only the court of history that will issue a balanced verdict.

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