As 2022 progresses, the economic growth/stock markets/inflation control trilemma that we have already discussed becomes more evident. Now we start to look at central banks' decisions and analyse how these will impact growth and financial markets.

Under the inflation targeting model, central banks in Latin America have taken the lead in raising interest rates to combat inflation. Even though economic recoveries have been slower than expected, interest rate increases have not significantly impacted local financial markets. However, these increases could induce a recession, as in the case of Mexico, where 200 basis points have increased the interest rate to 6% despite the fact that the economy has grown close to zero (0.02%).

Source: OBELA with data from FMI

Unlike in the US and Europe, subdued inflationary pressures allow central banks in many Asian nations to hold interest rates steady to help boost economic recovery. Although tensions have increased in India and Thailand, Asia enjoys low inflation rates compared to the rest of the world. In Japan, price growth remains too weak for the central bank to withdraw stimulus.

For the US and Europe, the situation is more complicated as the mere announcement of a potential increase in inflation rates was enough to send financial markets on a downward trend. At the same time, the economy has not been able to recover.

In Europe, the economic recovery in 2021 was weak, and the German Central Bank projected a recession in the first quarter of the year. Eurozone output remains below its pre-pandemic trend. High energy costs and Covid restrictions have dragged consumption down, and supply shortages weigh on industrial production.

In January 2022, the consumer price index rose to 7.5% in the US, while producer prices increased by 9.7%. These figures strengthen the argument for the Federal Reserve to raise the interest rate. Raising the interest rate could lead to a slower recovery and even a recession in this scenario. If the interest rate is not increased, with high inflation and the interest rate close to zero, the actual yield on treasury bonds is broadly negative. It is called financial repression. High inflation, in turn, leads to a reduction in real terms of US debt; this is the inflationary tax on debt.

The lack of yield on federal bonds creates incentives for investors to move their capital into financial assets such as stocks, bonds, ETFs or reserve assets (precious metals, gold or art) and commodities. Volatility in the latter represents an additional problem, as changes in their price affect the rest of economic activity. If the interest rate remains close to zero, prices will continue to rise and thus extend the period of high inflation. Still, if the rate starts to rise, the price will fall. Those affected are the countries involved in the production and export of raw materials unless China starts to stockpile physical materials as it already does with oil. The discourse of institutional investors reflects the expectations that the Fed will raise rates.

The ongoing conflict between Russia and Ukraine may impact global inflation. It would see an increase in minerals and basic grains, but especially gas and oil. The restrictions imposed would reduce supply and, in the worst case, a cut in gas supplies to Europe, which would have to source from the international market, creating intense pressure on energy demand. In this scenario, Asia, particularly China, would not have significant complications, as it has long-term contracts with Russia for the supply of gas at a fixed price.

These conditions, high inflation, negative real interest rates, low growth and the armed conflict, make central banks' tasks even more difficult. They will continue to struggle to keep prices stable while economies are only recovering from the 2020 slump.

Num 7, Year 2022, February 25th

- Bertin Acosta: OBELA; Faculty of Economics UNAM, Institute for Economic Research UNAM