The long and short of it: from ‘new normal’ to ‘old ordinary’

Arnab Das, global economic counsellor and macro strategist at Invesco, draws on macro history to try to put the present in perspective and navigate the future. This thought leadership commentary draws on policymaker and reserve manager discussions convened at Central Banking’s Summer Meetings in London.

Ideas from the past are back with a vengeance: populism and nationalism, fiscal and regulatory activism, industrial policy and subsidy, and superpower competition.

We should plan for politicised economic policy, and volatile, supply-limited growth-inflation cycles, alongside the demand-led cycles central banks are best able to manage, all of which imply an ‘old ordinary’ instead of a ‘new normal’. Inflation would need to be tamed with higher, more variable interest rates. For reserve managers, this presents the argument for larger liquidity tranches, or more dynamic liquidity/investment tranche allocations, and diversification by region and alternative reserve assets, including gold.

The old new normal

The term new normal first came into vogue after World War I. Given the enormity of what had happened, the world yearned for a new reality: so much of Europe and so many generations of youth had been laid waste. Much of the world was embroiled in an imperial contest, and the US intervened, as a democratic yet isolationist, superpower-in-waiting.

What followed proved neither normal nor new. President Woodrow Wilson had run his 1916 presidential election campaign on the slogan ‘America First’ – a pledge to keep the US neutral in World War I.¹ Yet, he ended up entering the conflict, then tried to establish US global leadership with the League of Nations, which Congress rejected. The US turned inward in a bid for the old ordinary: business was to be the business of America, not geopolitics. Self-enrichment resumed and the Roaring Twenties took off.

But this did not last, thanks to the Wall Street Crash of 1929, which triggered the Great Depression. Europe had paved the way to World War II, with war reparations on Germany that contributed to hyperinflation, deflation and the emergence of populists, nationalist socialists and fascists. The US returned to world war allied with the USSR, the UK and France, and their respective colonies.

So it took not one, but two world wars to foster a new normal. Russia did not trust Eurasia after Napoleon, Hitler, the Ottomans and the Mongols, nor did it trust the US after its two incursions.

Bipolarity replaced imperialism as a global system. Europe became the central theatre of the Cold War, having lost its seat at the top table of world affairs with its empires, its newly freed colonies were no longer battlefields for imperial wars of conquest.

Western, Japanese and small Asian economies reintegrated. The Soviet bloc remained separate, China in autarky and other emerging markets somewhere in-between as non-aligned states. This new normal persisted through the Cold War despite proxy wars, existential threats (such as the Cuban missile crisis) or macrofinancial boom-bust cycles that came and went in former colonies, but not in the West itself. Post-war resurgence in the West eventually yielded to Vietnam-era inflation, oil shocks and policy missteps with severe stagflation, requiring extreme monetary tightening, but no systemic financial crises, depressions or world wars.
 

The new new normal

Our modern new normal emerged not from a war-torn world, but a crisis-hit one – the global financial crisis that began in 2007–08 and the European debt crisis (2008–12). A time of lowflation, low growth and low interest rates, as well as ever-growing central bank balance sheets and asset prices, replaced a more cyclical world of higher trend growth and inflation.

Elements of the past persisted. Globalisation was not reversed. China kept advancing towards the technological frontier, overtaking the US in some areas. Yet US geopolitical, technological and financial primacy persisted. House price crashes, public debt crises and bank runs led to balance sheet recessions and repairs – recapitalisation, deleveraging, greater liquidity buffers and reregulation. Yet savings flooded capital markets, deepening financialisation. Optimism about the eurozone, the UK and emerging markets waxed and waned, but US assets took off in a secular ‘everything rally’ – stocks, bonds and the dollar, as well as illiquids and alternatives.

This new normal challenged reserve managers seeking secure incomes. Policy rates stuck at the effective lower bound – at or below zero – had nowhere else to go. Quantitative easing (QE) was required. A low-growth/investment/inflation mix required ever-more free money, growing bank reserves and central bank balance sheets to prevent deflation, validating falling bond yields and rising asset prices.

Reserve managers diversified for income

Negative bond yields put liquidity, capital preservation and return goals in direct conflict with each other. Negative yields meant capital losses at maturity. If yields rose, it would mean mark-to-market losses or losses crystallised on intervention (or sales from QE on domestic assets). ‘Convexity’ meant larger losses for any given increase in yields from ultralow levels.²

Extending duration did not help the reserve manager’s trilemma, but instead lowered liquidity and raised price risk for little incremental interest income. By diversifying into credit, or out of fixed income to equities, alternatives could help raise returns.

Changes from fixed to floating foreign exchange regimes also encouraged diversification by reducing the need for large, highly liquid reserves. Reserve drawdowns declined through the globalisation era, especially compared to the dollar-peg period (1990s–2000s) when yield-seeking inflows often switched to speculative attacks, forcing central banks to defend FX pegs.

Towards the old ordinary

History, it is said, does not repeat itself, but merely rhymes. We are now arguably returning from a post-crisis new normal to an old ordinary. Polycrisis³ has replaced the NICE [non-inflationary, continuous expansion] Age.⁴ Market and macro volatility is increasingly triggered by non-monetary drivers: fiscal shocks, trade wars, supply shocks, shooting wars, geopolitics and a global pandemic – sources of disruption for millennia before central banks were in existence.

Such shocks play out very differently from country to country. Developed market central banks are diverging significantly with differentiated policy rates as opposed to convergence near zero in the lowflation era. Balance sheet policy is also diverging. The US Federal Reserve and European Central Bank (ECB) are decreasing holdings with ‘run-offs’ at maturity, but with the ECB retaining the option to reinvest proceeds across member-state bond markets selectively. The Bank of England’s (BoE’s) active sales are crystallising losses and imposing fiscal pressure. The Bank of Japan (BoJ) has begun tentatively raising rates, yet has continued buying Japanese government bonds and growing bank reserves.

Liquidity, cash and reserves resume critical roles

Central bank balance sheets are likely to be larger as a share of GDP than in the pre-financial crisis/pre-polycrisis era. Reregulation of banks implies larger liquidity buffers, and major central banks now pay interest on bank reserves, raising bank demand for these reserves.

Central banks have faced severe banking, financial system and FX stresses, and heightened surges in the demand for cash and liquidity. Polycrises have hit reserve-currency issuing and holding countries.

Covid-19 pandemic lockdowns triggered a severe ‘dash for cash’ unlike any other on record – a selloff in Treasuries, Bunds and gilts, as well as risk assets – instead of the usual surge in ‘safe havens’.

Inadequately regulated/supervised US regional banks suffered runs – highly leveraged, insufficiently capitalised and illiquid, they were exposed enough to require a lender of last resort, and interconnected enough to precipitate systemic risks and exceptions to Fed emergency funding.

The UK suffered a short, severe financial crisis in the gilt market – arguably unique for a reserve currency issuer. Many noted how like an emerging markets crisis the simultaneous pressure on bonds, currency, risk assets and financial stability was.

Emerging market central banks drew down FX reserves amid bouts of risk aversion. Conflict or frontline states faced urgent cash and FX intervention needs in the face of FX, financial and banking system pressures, notably the central banks of Ukraine, Moldova, Poland and Israel.

The BoJ hiked rates slowly until early August 2024, when signs of greater US slowdown and more-than-expected BoJ hawkishness forced a reassessment of US-Japan rate differentials and sparked a sudden unwind.

The message of runs on safe havens stands out – even major economies with long-standing, strong institutions can lose their halos very quickly through mismanagement or miscommunication. Meanwhile, the return of severe pressures in smaller, less liquid emerging markets suggests that credibility via early rate hikes, self-insurance via large FX reserves and crisis avoidance – or even deft management in a crisis – does not prevent occasional, sizeable reserve drawdowns.

Information disseminated via the internet accelerates runs on banks, currencies and capital markets, raising the need for liquidity and faster central bank response times.

The revenge of geopolitics and geo-economics

From monetary dominance to politicisation

Central bank dominance in economic management is yielding to more interventionism and assertiveness by other state agencies – fiscal, regulatory, commerce and trade – which tend to be subject to greater political scrutiny and change. Central bank independence itself faces challenges. Domestic politics are also reshaping the global economy through foreign policy and ‘economic statecraft’. Geopolitical/geoeconomic tensions, major wars, trade investment restrictions, diverging national interests, ideologies and rivalries seem likely to persist.

Post unipolar: bipolar, multipolar or fragmented?

The world order is evolving, with China’s rising geopolitical/geoeconomic heft, Russia’s assertiveness and the rise of great emerging market regional powers such as India and Brazil. Whether, and how, the international economy remains largely integrated or evolves into spheres of influence, blocs or fragments, will inevitably influence central bank policy – including reserve management – by driving economies and markets.

Cold War 2.0: bipolarity or hedging/non-alignment?

When the Cold War began, the US towered over all others – its economy unscathed by war, protected by a nuclear arsenal. Unlike at the start of the Cold War, the West, China and most emerging markets are heavily integrated, despite derisking, friendshoring and nearshoring. The US may be pre-eminent still, but only as first among equals. China’s economy is smaller in dollar terms, but larger on a purchasing power parity basis. China shares borders with actual or nuclear-capable states, most with strong economic or security ties to the US.

Such competition already seems to be under way in Europe, given its close economic ties to the US and China, as well as security and ideological ties with the US. In Latin America, China is growing investment ties with Mexico, given its privileged geographic position and access to the US market. In Asia, the US is deepening economic, financial or security ties with Vietnam, India, Taiwan, Japan and Australia. In the Middle East and Africa, the US, China and Russia are all engaged in different ways.

Multipolarity – in which sizeable economies and actual or aspiring great powers chart their own course, may already be in operation. Several major emerging markets are continuing to trade with Russia despite the threat of secondary US/western sanctions.

Fragmentation – the deep integration of most major economies makes full decoupling seem unlikely absent direct open conflict, as in the case of Russia. Bilateral trade and investment barriers may have escalated, yet large trade flows are continuing or being redirected, not collapsing. We are seeing ‘reglobalisation’ – reconfiguration of global supply chains and associated investment and financial flows – not deglobalisation or fragmentation.
 

The old ordinary: diversification and liquidity

The world order, the global economy and markets are all in a state of flux. Bipolarity, multipolarity and fragmentation need not be mutually exclusive.

The new world order will likely include more supply-side limits to growth, with more volatile macro cycles that require higher interest rates to tame inflation. An era of polycrises implies higher market volatility, inflation and uncertainty. Reserve managers need to carry higher cash buffers that are more affordable in a world of higher interest rates. Bonds and fixed income are more appealing and useful in a higher-risk world.

Reserve managers could balance portfolios with a mix of cash, bonds and risk assets, to enhance returns and manage risks instead of exiting cash, as in a lowflation, low-growth, low-volatility world. Reserve managers might also opt to dynamically rebalance investment and liquidity tranches to manage risk/return trade-offs in quiet versus crisis periods.

Dollar dominance in the evolving world order

Would the dollar-centric reserve system and financial markets survive a shift from US unipolarity? Reserve diversification should make more sense in a multipolar, more volatile world of greater cyclicality and higher rates. Yet the challenge remains that ‘there is no alternative’ [Tina] to the dollar. Renminbi is constrained by capital controls, the euro by lack of a fiscal/political union, which means fragmented bond markets. Renminbi has gained market share in global payments since the war in Ukraine began. But so has the dollar, at the expense of the euro. US financial dominance may well persist in a multipolar or bipolar world.

All that said, when economic statecraft is returning, with financial sanctions involving the dollar system and access to traded goods, services, technology and commodities, gold’s rise and role as a hedge against geopolitical and financial instability seems likely to continue.
 

Notes

1. President Woodrow Wilson had campaigned using this slogan, which President Donald Trump’s 2016 campaign resurrected to signal a willingness to return to isolationism in international affairs, though, arguably, what emerged was more unilateralism in foreign policy generally and foreign economic policies in particular.

2. Convexity, formally, is the second derivative of a bond’s price-yield function, that is, of its relationship between its price and yield – itself a function of its maturity, coupon and duration (the first derivative). The longer the final maturity of a bond for any given coupon, the higher its ‘duration’ or interest rate sensitivity – a larger move in interest rates would translate to a larger move in price. This effect would be mitigated for higher coupon bonds, since more of their cashflows and payoffs would occur earlier, reducing the average life of the bond. In general, the lower the interest rate at the time of issue, the lower the coupon of a bond issued at par would be (a 100 face value, in any given currency). The lower the coupon and the longer the final maturity, the more convex or curved the bond’s price-yield function would be, in turn, implying larger price moves for any given interest rate change at lower interest rate levels.

3. Polycrisis is Columbia University history professor Adam Tooze’s term for the confluence of many simultaneous, severe crises that require immediate public attention and policy responses. Polycrisis is used here loosely to refer to any given set of crises experienced roughly in unison; polycrises refer to multiple or a set of crises experienced differently, at different times or in different places, extending Tooze’s concept.

4. The NICE Age is former BoE Governor Mervyn King’s term for an era of soft or falling inflation with relatively high growth, rather than boom/bust cycles.

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