US Federal Reserve officials are seeking to answer what they believe to be the most important question for the economic outlook. After inflation, jobs and spending data all came in higher than expected, they are concerned with knowing if monetary policy might again slip behind the curve. This dilemma will be scrutinised right up until the Fed's meeting later this month.
However, the more pertinent theory to explore might be that the world has become so addicted to borrowing that it will not stop no matter how expensive debt becomes. As a result, policymakers may no longer be able to control the pace of global economic expansion by moving interest rates up and down, because it cannot stem the amount of liquidity in financial systems.
More than a decade ago, central banks resorted to pumping trillions of dollars into economies to pull the world out of the 2008-09 financial crisis when they found setting rates close to zero could not stimulate growth on its own. This action may have created today’s challenges on the opposite end of the spectrum, with rampant inflation needing to be tamed and seven rate rises in the US last year alone having seemingly not had the desired level of impact.
By borrowing, companies are able to retain staff and operations and reward shareholders with buybacks. Usually when borrowing costs rise with interest rates, logic dictates that companies must cut back given they cannot keep adding increasingly more expensive debt. The suggestion is that this is no longer the rational approach when we have become so used to borrowing. The net benefit of all this liquidity has largely been to shareholders, corporations and bond investors.
JPMorgan has described the rise in debt since the global financial crash 15 years ago as nothing short of explosive, Reuters reported recently.
While total debt dipped last year for the first time since 2015, according to the Institute of International Finance, there is still about $300 trillion in borrowings worldwide. Combined global GDP is only about $80 trillion in comparison.
The ballooning of debt and its entrenchment in the day-to-day of business and economic activity are a direct consequence of historic monetary policies, even if it was unintended. Also, during the Covid-19 crisis, more debt was provided as support to economies and businesses around the world.
In early 2020, before the pandemic, it was expected that a tightening of monetary policy and a reduction in central bank asset buying would begin to roll back the amount of borrowing. Weaker companies that are alive only because of debt – also known as zombie companies – were expected to find that they were no longer able to attract capital and eventually would die, resetting the corporate landscape. Perhaps one fifth of American firms can be classed as zombies.
Their demise never happened to the extent that it should have done. The situation was never normalised and this has contributed to the ineffectiveness of monetary policy now.
Debt is no longer just one part of a diversified financial strategy, but an essential one. Regardless of its cost, like basic food staples, the demand remains high. Hence, high employment, resilient levels of consumer spending and runaway prices persist.
On Tuesday, Fed Chair Jerome Powell said that taking interest rates higher had become more likely now. “Although inflation has been moderating in recent months, the process of getting inflation back down to 2 per cent has a long way to go and is likely to be bumpy,” he warned.
So, if it is unlikely that the debt habit will be significantly reversed, despite borrowing costs being still on the rise, do policy setters have any control mechanisms left?
We could have a global economy where high prices and high interest rates are the norm. This is not good for anyone running a household or business, even if we still have income and revenue to count on. It creates unnecessary pressure and dampens innovation and creativity.
In the past decade, we have assumed that stock market rallies, commodity price rallies and other trends would follow a normal cycle of boom and bust. Instead, we have witnessed a kind of inertia where nothing ever comes down – such is the liquidity available to keep pumping into asset classes.
Even as central bankers double down on their current course, we could find that it does little to change facts on the ground in terms of inflation. So they will need to look in their bag of tools for something unexpected, just as they did when they reached for quantitative easing all those years ago. And if the bag proves to be empty, then it will fall to governments to intervene and introduce policies that do not allow the market free rein any longer, such as introducing wage, price and production controls.
Former British prime minister Liz Truss mooted something different last year and survived only 44 days in office after bond investors bared their fangs and drove the cost of UK debt higher. Ms Truss wanted to cut taxes without reducing spending to stimulate the economy and tackle both inflation and an energy price crisis. Her policies flew in the face of prevailing orthodoxy. She lost the battle and backed down.
Yet, if the current trend persists, there may be no other course of action for governments and we would be on a path to a war between markets and policymakers – a conflict in which neither side can blink and admit defeat. The fallout and volatility for that would affect global economic prospects for years to come.
The critical move now for the Fed and other chief central bankers is to begin working with both the public and private sectors to find an unorthodox plan, which they can all agree on, for when it becomes apparent that the Plan A monetary policy route is only making things worse for ordinary people.