In JM Barrie’s play Peter Pan, the audience is asked to applaud if they believe in fairies. If they fail to clap, the character Tinkerbell the Fairy will die. A Tinkerbell phenomenon is a phenomenon that only exists because people believe in it.
Central banks in the developed world are living in such a moment. For 30 years they have been the dominant players in economic policy, controlling the cycle through interest rate adjustments and quantitative easing. The primacy of central banks coincided with an era of low inflation; apparent evidence of their policy-making skills.
And investors also have confidence in the ability of central banks to rescue the economy in times of crisis. Stock markets tend to rally when central banks signal that they are about to ease monetary policy. Under Alan Greenspan, longtime chairman of the US Federal Reserve, this phenomenon was known as the “Greenspan put”.
Today, however, the expertise of central banks is being questioned. They have been caught off guard by the surge in inflation over the past 12 months and have been slow to raise interest rates to counter it.
To be fair, high energy prices, linked in part to Russia’s invasion of Ukraine, were a major factor in the rise in inflation. Andrew Bailey, Governor of the Bank of England, told the House of Commons that the central bank had faced an “almost unprecedented” sequence of shocks. But he added that “expecting 10% inflation and saying there’s not much we can do about it, it’s an extremely difficult place to live”.
This admission of impotence is rather clumsy. If central banks don’t deserve the blame for the recent jump in inflation, perhaps they don’t deserve the credit for the past three decades of moderate price increases.
Low inflation was boosted by China’s entry into the global economy, a move that flooded the developed world with cheap goods. Technological changes that reduced business costs also played a role. Maybe central banks weren’t exactly brilliant economic managers – maybe they were just lucky.
Another problem with Mr. Bailey’s admission is that the ability of central banks to manage expectations is crucial. If companies believe that central banks can control inflation, they will avoid passing on higher costs in the form of higher prices for consumers; if workers believe that central banks can control inflation, they will not demand higher wages in return for higher prices. But if they lose faith in the banks, it becomes a free-for-all, as it did in the 1970s. By that time, Tinkerbell was stone dead.
On this measure, confidence in central banks has not yet disappeared. It is possible to assess long-term inflation expectations on the futures market. This measure shows that investors only expect an inflation rate of 2.1% in the five years after 2027.
Still, the surge in inflation was an unpleasant shock to the bond market. The yield on 10-year Treasury bills, which was as low as 0.54% in March 2020, hit 3.43% in June, its highest level in more than a decade.
The yield on 10-year bonds has since fallen to 3%. Its recent volatility indicates that investors are now uncertain about the Fed’s ability to manage the economic cycle. Recent data has confusingly indicated that the labor market is still healthy, but consumer confidence has fallen and the manufacturing sector is still struggling.
But perhaps the greatest test of confidence in central banks occurs in the stock market. In June, the S&P 500 met the technical definition of a bear market when it fell more than 20% from its January peak.
In the past, investors might have hoped for a little help from the Fed in the form of lower interest rates. Instead, a few days later, the Fed unveiled its biggest rate hike since 1994, rising three-quarters of a percentage point.
Of course, central banks will argue that the “Fed put” was never a conscious policy. When they cut rates in the face of market turbulence, they weren’t trying to prop up asset prices, but to reduce the potential economic damage a financial meltdown would cause. Now that inflation has returned, central banks can no longer afford to worry about financial markets – they just need to slow down those price pressures.
Rather than playing the role of Tinkerbell, Central Banks have turned into Peter Pan’s crocodile who relentlessly pursues Captain Hook. Investors used to believe central banks would save them – now they fear banks will bury them.