Why this ex-central banker fears a second (and even bigger) mistake

Central banks are notoriously "behind the curve". But a former deputy governor, Stefan Gerlach, tells us why he holds even graver concerns.
Hans Lee

Livewire Markets

If there's one group of people who cop a lot of flak in financial markets, it's central bankers. Whether you believe they get too much or too little of it, they're the ones who print the money and make decisions that influence the wallets of billions of people. That was particularly true in 2022, as many on the economic spectrum were caught unawares by the surge in inflation (and its persistence thereafter).

And depending on which central bank you most closely watch, they may also provide intentionally vague answers - or at least, avoid giving the direct and certain feedback you desire. 

A beautiful example of this stems from Federal Reserve Chairman Jerome Powell. In his post-decision press conference last week, Powell argued "certainty is not appropriate". In layman terms, he's simply saying that singular data prints are not Gospel, even if financial markets may see otherwise.

Now, at this most crucial time in financial markets, EFG Bank Chief Economist Stefan Gerlach has granted us an exclusive interview about the state of the global economy and what central banks are doing as a result. 

Gerlach was the Deputy Governor of the Central Bank of Ireland between 2011 and 2015. As part of this role, he also sat in on the meetings of the European Central Bank under its former President Mario Draghi. 

You can watch or listen to the full conversation below or read our highlights summary.


How did central banks miss the inflation surge?

Gerlach argues a combination of unforeseen events created the inflation surge. 

"We've had two completely unforecastable shocks," Gerlach told me. "We tend to think of inflation rising because demand is very high or if we have a supply contraction. The problem with unprecedented economic events is that it combined all of these elements."

He also added that the shift in and out of goods and services added to the level of difficulty for central banks to determine when rate rises were appropriate. 

When I pressed him on the excess stimulus question, Gerlach said central banks simply just underestimated the impact free money would have on financial markets - not helped by the fact that monetary policy has a structurally long time lag. 

"We had a massive fiscal expansion in the US, and if the Fed immediately said that this will be inflationary and that it needed to be offset with tighter monetary policy, that would have been a very hard message to send," he added.

Reaction - and the risk of overreaction

One of the challenges central bankers face every day is the risk they have either overcooked or undercooked rate hikes. And as Jerome Powell highlighted in his press conference last week, that problem is a delicate one to solve especially given the time lag. 

"I think initially they were a little complacent. But when they finally did realise that inflation was surging, they responded extremely forcefully," Gerlach said.

He also highlighted the delayed effect of monetary policy changes, which typically lag by around 12 months: "So, this massive tightening will be felt really in the second half of this year."

But what about the risk they've over-hiked? Analysts continue to be split on whether a recession is coming to the United States but all that may change if the professionals switch their view on whether it was all handled too aggressively.

Gerlach is way ahead of them - arguing some economies may be heading into a recession because central bankers have made a second, even graver mistake.

"I think that risk is quite material in fact - moreso in some countries than in others. I am worried about what the ECB has been doing and I can see they may be triggering a recession," Gerlach said.

He then added he expects most developed market central banks to finish their hiking cycle by the middle of the year.

The key to understanding central banks: Be nice to them

This tip may sound a little controversial or even eyebrow-raising. But it is the essence of Gerlach's advice for understanding central bank messaging.

"I think it's very important to put yourself in their shoes. In financial markets, people tend to give very blunt and clear forecasts. Central banks are very different," he added.

At a more in-depth level, Gerlach has two tips:

  1. Central bankers look at time series, not single data points.
  2. A mistake costs a lot more at the central bank level. If they're behind the curve, it's because they cannot afford to mess it up.

Asset allocation in preparation for a recession

Goldman Sachs recently released a note that argued the Eurozone will not fall into a recession this year, a view that counters those of almost every other peer. Its reasoning was simple - the timing of China's reopening combined with a warmer-than-expected winter has given the European Central Bank some breathing room.

Gerlach contradicts this view.

"Unfortunately, I think it's too early to say. I think the answer will be unknown until the end of 2023," he said.

One theme he is bullish on is China - and he says the reopening of the world's second-largest economy has dominated many of EFG's asset allocation decisions.

"[China's reopening] is plainly a very good thing," he said. "I think it [comes] to the global economy at a good time."

As for one theme he thinks investors are not focusing on enough, he argues it's all about the "secular stagnation" thematic. 

"Is there a risk that, let's say, three or five years down the road, will all this fiscal expansion be undone? What will the situation look like?," Gerlach questioned. "Defence spending is increasing across the world right now. Is that a permanent increase? Or is that just something that's going to be seen for a couple of years before a cutback?"

"This could come back to haunt us," he added.

We hope you learned a few new things about how central banks operate and why their decisions matter so much to markets. We want to know what you make of Gerlach's comments about the risk of a central bank "over-tightening". Let us know your thoughts in the comments.

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Hans Lee
Content Editor
Livewire Markets

Hans is part of Livewire's content team. He is the moderator and creator of Signal or Noise. He also writes the LW-MI Morning Wrap on Tuesdays and Thursdays.

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