Central banks must play economic maneuvers in the dark

This week, the economic mood music shifted into a more anxious minor tone, as recent shocks to developed world economies resonated longer and louder than expected. Whatever you thought about the economy a week ago, you should be a little more worried than you were.

Inflation has been rising for some time – largely a sign that post-pandemic economies are a bit out of whack. Real household incomes fell sharply in many major economies at the end of last year. But following the war in Ukraine and recent shutdowns in China, the latest consumer price inflation rate in the United States stands at 8.5%. It is 6.2% for the United Kingdom and estimated at 7.5% for the euro zone.

Forward-looking economic indicators have been pointing to the risk of a slowdown for some time now, especially as households have seen their wages go less far. What began as a price shock was to lead to lower spending.

But, one by one, the indicators are now turning red. New manufacturing orders in Germany fell 4.7% in March. Shipping companies fear a plunge. The first quarter economic growth figures showed stagnation or outright contraction in several European economies. The US economy also contracted in the first quarter. The Bank of England predicts a contraction this year.

Central banks are therefore faced with a terrible set of circumstances. They must switch to a tighter monetary policy: rates are still very low and are stimulating activity even though inflation in the United Kingdom, for example, is expected to reach double digits. But the odds are increasing that they will end up trying to slow the pace of economies that are already shrinking.

This week the Fed and the BoE raised rates and signaled that more would follow. In the UK, the central bank is also predicting a sharp decline in household incomes and an economic contraction. The current problem is not just that rising rates in a weak economy can cause a lot of misery. Making unpopular decisions is part of the job; this is why central bank independence is so important. It is also that the right rhythm of normalization is particularly difficult to call.

It’s a time of incredible complexity: each week brought a new shock or revealed that the problems we saw coming were bigger than we thought. Markets have been back and forth this week in response to Fed announcements as participants grapple with how to weigh the whirlwind of news and position themselves in a still pricey stock market.

As Fed Chairman Jay Powell said this week, “It’s a very difficult environment trying to give forward guidance 60, 90 days ahead.” He’s right: 90 days ago, the world was still watching with anxiety a Russian buildup on Ukraine’s borders and Shanghai had yet to discover the unfortunate local coronavirus outbreak.

The staccato of recent crises has created astonishing uncertainty. We don’t know what China’s response will be to new outbreaks. We have yet to see to what extent the still thickening net of sanctions for Russia will crush other economies. We do not yet know the full effects of the disruption of food supplies from Ukraine and Russia for the world’s poorest countries. Inflation – and the need to protect the vulnerable from it – will upend politics in many states. And no one can say when it will all be over.

Central banks must be nimble. Investors need to be clear that signals from policy makers about what they intend to do in the future cannot be very reliable when the future is so murky. And all leaders should be honest that right now they can’t stick strictly to their scores. All anyone can do is play by ear.