Stories of Inflation, Interest Rates and Risk Premia | Company

Stories are a weapon of enormous power, the way the human brain deals with the complexity of reality. As Yuval Noha Harari suggests in Sapiens, humans have broken the evolutionary sequence of the law of the fittest through language and imagination. The ability to imagine realities and create believable and coherent narratives allowed them to control much larger population groups than would have been possible with the use of force. Religion and politics are palpable examples of this: compelling narratives that simplify complex realities and gather many followers. The problem is that sometimes the stories escalate and end up taking on a life of their own. Frauds are usually the result of consistent but misleading stories.

In economics, there are also stories that become dogmas far from reality. For example, lower taxes increase collection; that governments must act as responsible householders; that debt and deficits should be goals and not instruments of economic policy, or that central bank bond purchases always generate higher inflation. The imposed narratives determine the solutions applied to the problems and the policies adopted. And that is why it is important to check them, going into the details.

For example, the current debate over inflation. There is a narrative that holds that the excessive fiscal stimulus in the United States and the delayed reaction of the Federal Reserve and the rest of the central banks are responsible for the current very high inflation. The conclusion is logical: next time, the economy should be less stimulated. Simple and coherent conclusion, but probably incorrect. As a recent study by the San Francisco Federal Reserve showsnearly two-thirds of current inflation in the United States it is due to global supply constraints, for which neither monetary policy nor fiscal policy are responsible. In the euro zone, where inflation is set to pick up, the weight of supply factors is even greater.

The supply constraint chaining it generated a scarcity effect that caused prices to increase more than proportionally to the increase in demand. Combined with the general rise in the prices of all commodities, it has contaminated measures of underlying inflation, giving the false impression that the economy is overheating, when what is happening is that almost all economic activities suffered, simultaneously, from an exogenous increase in costs. Wages increasing much less than inflation, we cannot speak of second-round effects. Inflation expectations have risen, but only to finally be anchored on target after more than a decade at excessively low levels. Everything indicates, for the moment, a temporary increase in prices, and not a permanent increase in the rate of inflation.

This does not mean that interest rates should not be adjusted. The risk of upside inflation has increased and the success of the economic policy strategy designed to combat the covid crisis has rapidly reduced unemployment in the United States and the eurozone to historic lows. However, interest rates should also rise quickly to more neutral levelss, but without overreacting: uncertainty about gas supply in Europe is high, and the downside risk to growth linked to production stoppages in the second half of the year is increasing. Well-calibrated fiscal measures to support those most affected by price increases are a necessary complement to rate hikes.

The stories also affect the debate on risk premia in the eurozone. There is a narrative that if the ECB creates an instrument for managing risk premiums, it will jeopardize fiscal discipline in the eurozone. Simple and consistent conclusion, but also probably wrong. A bit of historical perspective helps. LCommon, high and procyclical risk premia, appeared when the euro zone committed its original sin: the decision not to mutualize the resolution of its banking crisis, and to condition the aid programs on the restructuring of the debt. This broke the solidarity implicit in a monetary union and changed the nature of peripheral country bonds, which came to be seen as risky assets, limiting their investment universe. Lack of institutional support led to excessive reductions gradesand the ECB’s decision to use the grades in its bond buying and collateral eligibility decisions, it amplified and perpetuated risk premia. The ECB is the central bank of each of the eurozone countries, and therefore it should accept bonds from all of its countries – just like other central banks do.

Empirical evidence is stubborn with narratives. Since the ECB started buying bonds, and despite limited risk premia, the fiscal behavior of euro zone governments has been responsible. In addition, the euro zone’s fiscal framework has been strengthened, limiting the likelihood of a repeat of the Greek tax evasion. Current risk premia are amplified by two factors: the likelihood that a bailout will force restructuring and the likelihood that a country will decide to leave the euro. The first is a political decision on the structure of the euro zone. The latter will depend on whether or not the economic framework of the euro zone is attractive for all countries.

An accelerated and unjustified rise in risk premia puts excessive pressure on monetary conditions, prevents the ECB from achieving its objective of price stability and increases economic divergences in the euro zone. Once it is accepted that the behavior of risk premia is amplified by the original sin of the euro area, and that they are an integral part of financial conditions, the concept of managing risk premia – not removing them , let’s be clear – makes perfect sense. Whether it’s the ECB through a well-designed instrument with the necessary safeguards, whether it’s governments through the necessary reforms of the euro zone’s budgetary framework, whether it’s a combination of the two, it’s a decision that corresponds to the leaders of the euro zone. But it is a decision that cannot be avoided, nor should it be hidden behind false narratives.

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