Money & Markets: Taper Tightening and Tantrums

In normal times it is still the case that industry cannot survive without a never-ending supply of debt from which to borrow. With the pandemic, the only way economies could survive pandemic countermeasures was for governments to artificially create great quantities of new money, forcing it into the financial system to bail everyone out. There is hardly an engineering company in the world that would survive the freezing of the debt markets because without the ability to roll the bonds and loans all large companies carry, they would become insolvent and fall into bankruptcy. This is why when central banks speak, everyone listens, because they control the levers of that system and even small changes have big impacts.

As I write it is not proven but it is definitely hoped that the Omicron variant of Covid, while wildly infectious, is not a killer and that it might even act as a road to herd immunity. This could see an end or at least the beginning of the end to the vast dislocations wrought by the Covid pandemic

As someone who nearly won a place in the choir invisible thanks to the ‘Kent variant’, I certainly hope so, but back in the material world Covid remains the driver of all markets. The key driving linkage between the pandemic and financial markets is stimulus and liquidity operations from governments and central banks. Without these institutional interventions, markets and economies would by now be a wasteland of the financial contagion of bankruptcies and defaults. While people are bound to moan about the inflation this will create, it is hard to imagine the depths of misery the austere alternative would have dealt.

These operations have levitated critically wounded markets and given investors and speculators a nice payday. Those down the financial ladder are also not doing so badly it would seem, with large numbers quitting their jobs and, at least for now, not keen to go back to low-pay work.

Printing money has always been an opium for governments and their peoples, and it is understood that to have strong growing economies inflation has to be kept down to creeping levels. There is a ‘goldilocks’ range around 2-3 per cent and any more or less hurts growth of economies. However, when disaster strikes there is only one way to stop the financial dominoes from falling in cascade and that is to print new money and, in the case of Covid, oceans of it.

It’s anyone’s guess how much inflation is already baked in and my wild estimate is somewhere around 50 per cent, with more likely to be created in the coming months and years.

This printing is slowing and this is the taper. This is best seen in the US where the central bank runs a soap opera of public statements of monetary policy intent. The current ‘liquidity measures’ which most consider as being money printing are being ‘tapered’ and are set to end in the spring of this year. This is not yet carved in stone because Omicron is still a wild card that might require more money to be magicked into being to get the world economy across the pandemic divide. Yet tapering is going to end the flow of new money soon.

So once the taper is complete, the rivers of new money flowing into the oceans of new cash will run dry but the ocean will still be there. Then comes tightening.

Tightening is feared because whatever good news comes from ‘new liquidity’ is reversed. Rather than going up, the markets go down. Rather than companies being able to borrow money easily, suddenly it gets tricky. Rather than being saved from bankruptcy, companies go bust.

So a cynic will say, it’s not going to happen – and I agree.

People will say, 'but, but, interest rates will go up and that is tightening, so tightening will happen'. That is not the case. It was in the old days, when interest rates went up because money was hard to find and the demand and supply balance for money created the rise in interest rates. In the new world of ‘unorthodox’ monetary policy, interest rates can go up but the supply of money can stay the same or even rise. So while interest rates will rise, money supply need not and will likely not be strangled off.

This will avoid a ‘taper tantrum’ and a ‘tightening tantrum’ where the markets swoon on the prospect of a choking off of money supply. After I wrote the bulk of this article the Federal Reserve announced they were keen on the idea of tightening but implied that would be decoupled from interest rate moves, and of course being able to zig and zag on how much money is to be had is more flexible than simply whacking the whole economy with the blunt instrument of interest rates and letting the devil take the hindmost.

Higher interest rates alone will chill inflation to an extent but for now countries’ deficits to GDP need to be normalised by inflation. So while there will be plenty of anti-inflation posturing, real tightening to squeeze it out won’t happen until debt to GDP ratios are back within tolerances. That is two to three years, perhaps five years, out.

So, the party will roll, albeit at a significantly slower rate for some time to come, and tapering and tightening will be a cause for anxiety but not panic.

While the past is meant to be no guide to the future, it is interesting to note that the last time the US Federal Reserve tried to tighten even a little, in 2018, the market dived. As such, so-called quantitative tightening is not likely to be on the cards for a long time to come.