The long and short of it: Central Banking case studies in point

Invesco comments on the case study interviews conducted by Central Banking for this report, and key reserve challenges such as global high inflation and balance sheet dynamics in emerging and advanced economies. 

Central Banking’s case studies around current challenges for developed and emerging market central banks – high inflation, monetary policy responses and central bank balance sheets – cover all bases. Responses span diverging macro/financial experiences and policy responses to shared economic shocks. Diversity within a wide confluence of higher inflation, tighter monetary policies and shrinking balance sheets is critical for policy-makers, market participants, reserve managers and private market participants. 
 

From lowflation to highflation amid differentiation

Supply-side inflation

Within a near-global inflation surge lies a gamut of inflation experiences. This ‘highflation’ is not yet for the history books – it is still unfolding. The economic experience of recent years suggests supply-side inflation has made a comeback via repeated, unprecedented and unexpected commodity and terms‑of-trade shocks, spurred by the Covid-19 pandemic and the Russia-Ukraine war. 

Supply-side highflation probably originated in spending shifts from services to goods during lockdowns, and back to services on reopening, plus shifts in labour markets. Initially, goods supply chains were disrupted before firms and countries – notably China – found ways to enforce lockdowns while keeping factories running. 

Professional services – such as law, finance, many aspects of business and even medicine – also continued in a virtual or hybrid manner. But face-to-face services – including tourism, leisure, hospitality and many household services – could not, and bore the brunt of lockdown policies. 

Reopening substantially reversed this, with demand for services and experiences surging and switching from an oversaturated demand for goods. Yet supply factors aggravated these outsized shifts in demand and spending patterns. Labour markets became very tight because of pandemic-related early exits through retirement, changes in preferences for types of work, fatalitities and cases of long Covid.

Then along came another type of ‘imported inflation’ – a terms-of-trade shock triggered by Russia’s invasion of Ukraine. The two countries normally together account for vanishingly small shares of global growth, activity or price formation. Yet they have disproportionate effects on many crucial components of global supply chains. From basic primary commodities – oil, gas and soft commodities such as food grain – to specific components in the auto supply chain for which there were few immediate alternatives.

The result has been a massive relative-price shock, driven by shifts in spending patterns and global prices. This is not the sort of general rise or fall in domestic/demand-driven inflation that central banks normally manage or mete out via macro-stabilisation monetary policy. 
 

Fiscal push and demand-driven inflation 

However, demand-side boosts to growth and inflation – due to joint fiscal/monetary policy responses to the pandemic and war – have also made a substantial difference. The US, more than other major economies, produced a wartime level of fiscal support – $5 trillion in two years, over 20% of GDP cumulatively – substantially financed by Federal Reserve quantitative easing. As a result, US household disposable income, savings and wealth were turbocharged after an initial lockdown-driven collapse in jobs. Europe experienced similar, if smaller, effects. At this point, fiscal and monetary policy were working hand in hand to support households and the economy to different degrees throughout the West.

Once the war began and drove up commodity prices, the US, being nearly self-sufficient, did not suffer as much as Europe, which experienced a massive surge in food and especially energy prices. Fiscal policy came into play once again, as energy price controls were imposed, funded by fiscal subsidies, supporting discretionary spending and pushing headline inflation into core inflation amid the post-pandemic resurgence in demand for services.
 

Diversity amid widespread policy tightening

Developed market versus emerging market central banks

The reaction to highflation diverged across developed and emerging market central banks. Many emerging market central banks saw the inflation shock as more persistent and threatening – requiring a sharper, stronger policy response – than most developed markets. 

Why? In hindsight, it’s ironic: emerging market central banks worried more than their developed market counterparts about terms-of-trade or supply-side inflation shocks becoming persistent because inflation expectations have long been less anchored in emerging market economies. In other words, emerging market central banks were probably quicker to act because they had to be – their inflation expectations were more adaptive and less inertial. Developed market central banks were in a more comfortable place – some might say complacent. As a result, many emerging market central banks switched quickly from historically aggressive easing with even more aggressive rate hikes than major western central banks, which raised rates more rapidly than in the past several decades of secularly falling inflation. 

Views that inflation would prove transitory – and therefore it would be best to look through supply shocks – have proved incomplete at best and downright incorrect at worst. Policy had to be tightened aggressively, yet headline and core inflation are now both starting to fall, and the global economy has proven remarkably resilient. 
 

Exceptions to the rule: China and Japan

Throughout the resurrection of inflation in the West and many emerging markets, China and Japan have stood out – in different ways. China has the biggest differences, as reflected in being the major economy that stands out for easing policy after reopening, in contrast to hawkishness almost everywhere else. Chinese households experienced more frequent, and arguably more intensive, lockdowns than other countries, with less monetary or fiscal support. Plus, pressures in equity and real estate markets translated into wealth losses, rather than gains. This is probably why excess savings continue to be held rather than spent, unlike in other major economies. This is why China is easing rather than tightening after reopening. 

Japan is the only large economy maintaining a dovish/neutral, gradualist approach to normalising – perhaps not even tightening – though for very different reasons than China. China is easing to boost growth and inflation – which are below potential and bordering on deflation, respectively. But the Bank of Japan’s concern is that premature normalisation – and restrictive policy – could cause another false dawn. Decades of deflationary pressures have left expectations anchored too low, unlike in the West and emerging markets. Japan is going to go slow.
 

Central bank assets and reserves

Monetary policy portfolios versus reserves portfolios

The combination of high inflation, rapid rate rises and quantitative tightening has inevitably created large losses for major fixed income holders, central banks and private investors alike – in particular where much of the buying was across the yield curve, especially long-term bonds. Indeed, losses at the long end have been accentuated at ultra-low or negative yields by convexity – the curvature of a bond’s curved price-yield relationship. The bond trader’s cliché says that “convexity is your friend”, to some extent insulating a bond’s price from modest moves in yields. But large moves from low yields mean large moves along the price-yield relationship and enlarged losses. 

Predictably, the liquidity/safety/capital preservation/return hierarchy for foreign exchange reserves – especially liquidity portfolios – helped weather the storm to some degree better than private investors or domestic assets acquired through quantitative easing. Mark-to-market losses have been hit by rate rises but, thanks to their short-term nature, have been smaller than longer-term policy portfolios and better offset by rising interest income from higher policy rates and market yields.

Of course, both the larger losses on long-duration bond portfolios and the greater income benefits of higher yields reflect offsetting monetary policy decisions. During the descent, amid lowflation, towards the lower bound in policy interest rates and the adoption of quantitative easing, investors reaped capital gains in bonds and most other financial assets – at the cost of interest income. During the ascent, amid highflation, capital gains were reversed but interest income is back. 

Ultimately, both policy and reserve portfolios were functioning as intended. That may be small comfort given the losses involved, but this has to be accepted when macro regimes switch from far-below to far-above target inflation. 
 

Gold

None of the central banks in the case studies have been active in gold recently – which is consistent with most central banks, especially in developed markets. The data, however, is clear: the key trend is that central banks have been among the most important and active gold buyers in global markets, for different reasons. 

Some have been buying gold because of geopolitics, perhaps none more significant than the Bank of Russia (BoR), given financial sanctions and the freezing of half of its FX reserves in retaliation for the invasion of Ukraine. Indeed, the BoR seems to be buying and holding gold onshore, since Russia is a major producer. Russia is reportedly buying imports, including sanctioned items, in exchange for physical gold, in its de-dollarisation drive. China is another major buyer of gold, probably to diversify away from the US dollar and US treasuries. 

India, Turkey, Brazil and other emerging market central banks have also added gold reserves since the global financial crisis that began in 2007–08 and the eurozone crisis – long before the Russia-Ukraine war and current rising geopolitical tensions. This may be partly about trust and confidence in western financial systems and fiat currencies, but also for domestic macro reasons. Turkey has used gold to shore up the lira during high-inflation episodes, and Indian citizens tend to save with gold jewellery and have tended to buy gold amid high inflation. But, for these and most other countries, FX intervention with reserves is likely to remain an important part of the macro/financial stability toolkit. 

The macro and geopolitical backdrop suggests emerging market central banks will probably continue to buy gold. Many are overweight with dollars and treasuries, and underweight relative to advanced economy peers, which, in many cases, retain large holdings from the gold standard era. 
 

Diversification

One clear message from the case studies is consistent with Invesco’s macro-strategy views and client conversations: the world is ripe for selective diversification by asset class and region. With the US, Europe and emerging markets at or near the end of tightening phases, adding duration for long-term portfolios is now much more in vogue and at higher yields than when inflation was high, rising and surprising to the upside. 

China is at the opposite end of the scale: near the start of its easing cycle at a time when its large economy is experiencing a structural and natural deceleration in trend growth driven by demographic transition, and gradual rebalancing from trade, investment and catch-up-led growth to domestic demand, consumption and services. This points to a more structurally bond-friendly environment, with opportunities to rebalance across duration and risk assets.

Japan is arguably somewhere in the middle, with further pressure likely in Japanese government bonds as yield curve controls continue to be relaxed. With a gradualist, dovish approach to policy normalisation, risk assets including equities could continue to do well, narrowing the valuation gap with the rest of the world. 
 

Conclusion: a challenging world for central bank policy and reserve management

Invesco does not expect deglobalisation, but ‘reglobalisation’ – a restructuring of global trade, investment and financial relationships. Integration has progressed so far that it would be extremely costly and disruptive to decouple – except in the extreme scenario of a future direct or proxy conflict, as between Russia and Europe. 

However, the world economy is undergoing accelerating structural economic change. Supply chains are being reorganised for resilience, national security, climate change, inequality and ideology. Governments are intervening in economies and financial markets with industrial, trade, regulatory and fiscal policies. Physical investment is being stepped up in many regions for all these reasons – and at a time of labour shortages due to demographic transitions in most large economies. 

All of these changes add up to a more supply-driven and constrained world, rather than the demand-led world that prevailed in the decades of globalisation and secularly falling inflation, when central banks often had to push inflation up towards targets. In the world that lies ahead, the policy challenge may well be to drive inflation back down towards targets. 

This is likely to mean loose, active fiscal policy often at odds with monetary policy, requiring higher interest rates than in the world of private-sector deleveraging and fiscal austerity that prevailed between the financial crisis and the pandemic. 

Furthermore, government intervention in economies is likely to be very between countries – instead of similar policies converging on a free-market model as in the heyday of globalisation. 

For central banks as for policy-makers, this is likely to be a tougher world to manage, since inflation is more likely to be led by supply than demand, and arise through changes in relative prices or headline inflation more often than domestically generated core services or wage inflation. Yet, for reserve managers and investors alike, we are likely to see a world with more interesting possibilities for diversification, both by country/region and asset class.

 

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^{Data as at November 13, 2023 unless otherwise stated.} 

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