The money created by the Fed and the ECB increasingly finds its way to the central bank by being deposited there.

The dynamism of the economic recovery after the recession triggered by the pandemic surprised central banks in particular. At the same time, a decade of persistent deflationary pressure has created a rarely seen tolerance for higher inflation by major central banks.

The Federal Reserve and the European Central Bank (ECB) are the most explicit in this regard by including tolerance for exceeding inflation in their monetary strategy. The cautious approach to withdrawing monetary stimulus certainly has its merits. Financial conditions have been a positive wind for economic growth throughout the recovery. At the same time, it is fair to ask whether an aggressive stimulus policy is still appropriate when abundant demand meets insufficient supply in many categories of goods and services. Moreover, the absorption of the money that the Federal Reserve and the ECB create by buying bonds seems to stay in the financial system.

Loan growth and credit creation are rather poor despite record rates and flexible loan terms. The money created by the Fed and the ECB increasingly finds its way to the central bank by being deposited there. These are strong indications that quantitative policy measures are currently unnecessary. In addition, unintended consequences of providing too much money on too attractive terms are starting to emerge.

House prices in the United States have risen more than 40% above the level recorded during the subprime mortgage boom that peaked in 2006. Valuation measures such as rental prices are also approaching record highs , which contributes to the idea that there is too much money in the system. The Fed is starting to recognize that there are unwanted side effects of asset purchases. He therefore chose to report a reduction in asset purchases starting in November and ending them in the middle of next year. Thorough thinking about what the financial market reaction might be played an important role for the Fed. The start of the reduction in November was earlier than median expectations, but well within the range of uncertainty and therefore well assimilable for financial markets.

We expect the Fed to be figuratively held hostage to financial markets in the future. The reason is that monetary policy has, in the current recovery, a much larger impact on financial markets than on the economy. The ups and downs of the economy had been caused by an orderly shutdown followed by a reopening of the economy and generous budget support giving a central bank little control over the situation. Most central banks have accepted their responsibility to ensure that the pandemic crisis is not exacerbated by turmoil in the financial markets.

The responsibility for a proper economic recovery is a business today. The Fed and the European Central Bank find themselves in the comfortable position that the vigorous economic recovery is largely self-limiting, as supply bottlenecks, rising prices and depletion of stocks dampen current demand, transferring it to the future. Other central banks, such as the Norges Bank or the Bank of England, see more the need to act early and prevent the mismatch of supply and demand, which pushes up prices, from causing a self-sustaining inflationary spiral. This is even more true for central banks in emerging markets where higher inflation often leads to currency depreciation, resulting in increased imported inflation. In order to avoid such a self-fueling inflationary spiral, the central banks of Brazil, Mexico, Chile and Hungary have already raised their interest rates. The pressure on the Fed, the ECB, the Bank of Japan or the Swiss National Bank to follow this example is weak.

Exchange rates are more stable and imported inflation is a less serious problem. At the same time, the constrained real economy demand for the abundant and cheap funds offered by the financial system allows the Fed and the ECB to stick to the slow and predictable way of reducing stimulus measures. monetary policy for the benefit of financial markets.

As far as the Middle East is concerned, the normalization of monetary policy by the Federal Reserve brings back bad memories. The rate hikes at the end of 2015 led to a stronger US dollar and came after the oil prices fell. Countries with currencies indexed to the Middle East had to follow the Fed despite domestic conditions that did not call for higher rates. Higher oil prices today make it easier for a number of Middle Eastern countries to cope with higher rates.

The writer is Julius Baer’s chief economist. The opinions expressed are his own and do not reflect the policy of the publication