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The leading central banks hold the financial markets in their hands. Last year they took us to new summits for global share prices. In response to the pandemic they drove interest rates down to zero and below and promoted a long and large bull market in government debts. Now they are wobbling in their support.
They show growing remorse for the inflation they see around them while being reluctant to accept the blame for it. China is the exception as the central bank injects some cash to prevent a regulatory attack on property companies from leading to a collapse in the banks that have lent to the sector.
China avoided zero interest rates and quantitative easing. It has a more modest level of consumer inflation. It also suffers from the commodity and component inflation seen globally. The fears I expressed in my last column about the prospects for 2022 — inflation, monetary policy tightening and growing political tensions — have become more visible in the first month of trading.
Last year, central banks were forced several times to raise their estimates of inflation as price rises started to come through. With one voice, they told us this would be shortlived, reflecting supply disruptions relating to the pandemic measures taken by governments.
They promised to look through the turbulence, to carry on promoting growth and to expect a natural subsidence in inflation as more normal working resumed. Bond and share markets were largely untroubled and shares — particularly in the US — performed well.
This year, led by the US Federal Reserve, the talk is all of tightening credit and money by ending all official bond buying and raising interest rates. With the exception of Japan, which still faces an inflation rate of under 1 per cent, the advanced countries are all in the same boat. They did not take the action they should have taken last year to control inflation before it set in. Share markets have been losing trust in the wisdom of central bankers. There is a danger they end up doing too much too late.
Inflation is too much money and credit chasing too few goods. Central banks, through their position at the heart of the banking system, can regulate the amount of money around. They control its price through fixing interest rates and intervening in debt markets. Higher rates should lead to less credit and less activity.
They can control its volume by setting lending rules for commercial banks, such as ordering higher levels of cash to be held against bank deposits. In the glory days of the German central bank, before the euro, they managed a policy which produced low inflation and good growth from the German economy by controlling the amount of money they allowed to circulate.
The European Central Bank took over when the euro launched. It joined the Fed and others in guiding policy not by money figures but by a study of inflationary pressures within the real economy.
These banks have a theory that they can judge the total capacity of the economy they serve. If demand is too close to capacity, they say they need to tighten to stop inflationary pressures. If demand is too far below capacity they need to offer monetary stimulus to narrow the gap. They have been changing their mind about where we are relative to capacity in recent weeks.
There is more judgment involved in assessing capacity than in measuring the amount of money available in bank accounts and cash holdings. I remember from my days in industry that the capacity of the factories was elastic. You might be able to run an extra shift or two, going from a one- or two-shift day to a two- or three-shift 24-hour pattern. You might have stock to clear. You might have a spare line to reopen.
At other times you could not hire good labour quickly, or your component supply was constrained if you wanted to lift output, or your factory was fully stretched and your stocks already too low.
If economies need a sudden surge in face masks, it is possible to step up their production quickly by diverting from other comparable products. If we are all short of microprocessors it takes a couple of years or so to design, build and bring on stream a new large chip factory — or three to resolve the global shortage.
Although the central banks do not target money growth, the result of their actions this year will be to slow it down in the advanced countries from the extraordinary rates deployed to counter lockdowns. If they judge this well, do not panic and do not curb it too much they can experience the soft landing that market bulls expect.
We could see the worst of the price rises this spring, to be followed by reductions in the pace of increase. This assumes wage growth stays below the high price rises of the peaks, and many of the shortages are gradually resolved by adding more capacity.
The dangers are to both sides of this happy median. If scarcity of labour and reluctance to return to the workforce embeds high inflation levels in pay, price rises will persist, forcing tougher central bank action of a kind share and bond markets will not like. If the central banks forget again the long lags and fret themselves into acting too much anyway, chasing historically high inflation after it is tailing off, we will also have a bear market.
To those who see inflation in terms of too few goods, the outlook is mixed. We have seen bad shortages of containers and ship capacity, of timber and oil, aluminium and gas, electronic chips and of certain foods. Individual brands and products have run low, reflecting demand surges or shortages of raw materials and components.
The worst is the general shortage of energy. Low wind levels in countries depending on wind farms have exacerbated the gas shortage as power generation has switched to fossil fuels. Russia has been playing with gas volumes in Europe, while Opec has kept some controls over oil volumes.
The West’s wish to transition quickly to green energy has set in train major reductions in coal and nuclear generating capacity which needs replacing with something better. The shortage of lorry drivers is gradually easing as more people are trained and wages and conditions improved. There are more container ships on order now, promising an easier time from next year. There is also a move towards more national self sufficiency as people learn of the ways in which over-extended global supply chains can leave you short.
Markets tell me that as interest rates rise it is the growth sectors that will suffer most as we need to discount their future cash flows at a higher rate. While that is true, higher interest rates can also hit more heavily borrowed cyclical and mature companies and inflation makes life difficult for companies seeking to add modest value to volatile and inflation-prone raw materials.
The fund has held 22 per cent in cash against these troubles, the best part of the portfolio in January. I am glad I took substantial profits on some of the global clean energy assets and some of the digital holdings last year. The main equity holding to keep the fund with its balanced rating is in the world index, which fell over the last four weeks. There are good reasons to worry about quite a lot of specialist sectors and strategies in these conditions.
Sir John Redwood is chief global strategist for Charles Stanley. The FT Fund is a dummy portfolio intended to demonstrate how investors can use a wide range of ETFs to gain exposure to global stock markets while keeping down the costs of investing. john.redwood@ft.com
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