Liquidity Tidal Wave.

To WHAT EXTENT is today's massive global ocean of liquidity breaking all the rules in U.S. financial markets?

If you trade U.S. Treasury securities or equities these days using the traditional rules for how markets function, you probably are ready to give up and head for higher ground.

Last May, for example, the Federal Reserve began its discussion for future tapering. By early November, U.S. equity markets had rallied another 14 percent. At that time, the ISM services sector data was the strongest in history. Still, real interest rates continued to be the lowest in history. Inflation soared to three times the Fed's target. Yet at one point during this rise, the ten-year Treasury bond experienced an eye-popping rally. Meanwhile, the greatest asset bubble in history continued to grow with surprisingly little correction until recently.

What's going on? Is today's giant swirling global ocean of liquidity the new master of U.S. financial markets? The global financial ocean first expanded after the fall of the Berlin Wall, with new entrants to the capitalist system such as China and India. The dramatic expansion of central bank balance sheets added to the situation.

What's the situation today? Europe and Japan, both with negative interest rates, seem to have ceded global leadership in technology to the United States and China. With China's return to a new form of Maoism, its bonds are highly risky. And as Chinese GDP continues to slow as a result of demographic and debt concerns, emerging markets are taking a hit.

By contrast, the U.S. Treasury's ten-year bond even at 1.9 percent (1.5 percent as of early November) looks relatively appealing. America's banks are well-capitalized. While American politics are essentially dysfunctional, the result has been a market favorite--divided government. Why shouldn't extraordinary amounts of global liquidity be pouring into the United States?

But what, if any, will be the long-term consequences of this current situation where rising liquidity has swamped the U.S. economy's price and market indicators of earlier times? More Bitcoin-type rocket scenarios? Or is this global liquidity effect being exaggerated?

Two dozen important analysts share their views.

JEAN-CLAUDE TRICHET

Former President, European Central Bank

During the last ten years, between the Lehman Brothers bankruptcy and the Covid-19 crisis, advanced countries' real economies experienced unprecedented disorders: much lower productivity growth, lower real growth, extremely low real interest rates, and abnormally low inflation. After having concentrated for many years on fighting deflation and then countering the dramatic Covid-19 crisis, they have now to cope with abrupt significant price increases.

Even if we put aside the exceptionally high level of headline inflation, which is under the influence of the global prices of oil, gas, and some commodities, the jumps observed in the level of core inflation are alarming. In the United States from July 2020 to November 2021, core went from 1.3 percent up to 4.9 percent (2.5 times over the 2 percent medium-term target). In the euro area from July to November 2021, core went from 0.7 percent up to 2.6 percent. In both cases, core inflation tripled and quadrupled in a short span of time!

During the global financial crisis, all advanced-economy central banks issuing the currencies that are in the basket of SDR converged toward the same definition of price stability, namely 2 percent in the medium run, in order to solidly anchor expectations. I consider this conceptual convergence, also visible in several other fields (banking surveillance, systemic risk monitoring, communication, and so forth), as one of the most consequential events in monetary policy since the dismantling of Bretton Woods.

For the U.S. Federal Reserve, the ECB, the Bank of England, and the Bank of Japan, the commitment made to fellow citizens, economic agents, and market participants to ensure price stability in the medium and long run is more demanding than before: the goal is precisely defined. And the travails of the three first central banks--Japan being a special case--to ensure price stability are likely to be difficult because of the many years of exceptionally accommodating policies. The four central banks mentioned earlier are still, as I write, at zero or negative interest rates and have accumulated around $24 trillion (significantly more than the 2020 GDP of the United States!) of purchases of tradable securities in their balance sheets. These enormous amounts are unprecedented and have had consequences, in terms of financial and asset markets bubbles and the distortion of economic agents' decisions.

I do not think the monetary policies of recent years were wrong. They were designed to prevent the materialization of deflation and, as regards the last two years of pandemic, the overall collapse of the economic and financial sphere. They succeeded. Central banks were up to their responsibilities, but it was an enormous mistake to leave them almost completely alone in the decade's battlefield.

I see four responsible entities that should have contributed to redress the advanced countries' real economic situation and therefore alleviate the burden of central banks.

First, governments and executive branches should have embarked much more resolutely in those structural reforms that are key to enhancing productivity and growth: reforming the labor market, improving mass education, financing help for students of excellence, professional training, technological innovation, and more.

Second, governments, entrepreneurs, and social partners should have realized much earlier that very low inflation was also due to the quasi flat nominal unit labor costs in many advanced economies. Strangely, only very recently was it realized that the significant weakening of the bargaining power of labor and ensuing inequalities were not only a major political problem, but also an important monetary and financial problem.

Third, central banks would have benefited from the minimization of financial unintended consequences if macroprudentials had been used significantly more resolutely. In this respect, the success of applying the new prudentials for banks after the global financial crisis was unfortunately not matched by financial market macroprudentials. Today, potential financial market instability is a major issue.

Fourth, the reader might be surprised that I ranked fiscal policies only as fourth on the list. In the eyes of many who assign macroeconomics to the sole mix of monetary and fiscal policies, it goes without saying that significantly more accommodating fiscal policies were the appropriate way to alleviate the central banks' burden. I do not dispute this view as regards the Covid period for all and, before Covid, for those countries and economies that had a significant fiscal space such as Netherlands, Germany, and Austria. But it was not a good recommendation for Japan, the United States, the United Kingdom, Australia, Canada, France, or Italy--economies which have a tendency to post high public debt outstanding as a proportion of GDP and/or significant public and current account deficits. In the near future, interest rates will be significantly higher also because of the green transition and its required investments, which will eliminate the savings glut and push up real interest rates.

In these extremely demanding circumstances, I would express two wishes. First, central banks should ensure credible anchoring of inflation expectations in line with their medium-term goal. This is absolutely key for the support of fellow citizens.

And second, central banks should not be forced to battle today's problems alone, as well as the new major difficulties that are likely to materialize in the future. If this becomes the case, I expect them to be more eloquent than in the past in calling upon all their partners, including political authorities and social partners, to step in and help.

JACQUES DE LAROSIERE

Former Managing Director, International Monetary Fund, and Honorary Governor, Banque de France

What is strange is not so much the current outburst as the astonishment it arouses. All the disruptions we are witnessing--particularly inflation's upsurge--have been carefully prepared over the last fifteen years.

I personally have never understood the "rationale" behind the major central banks' policies. These have been continuously accommodative, regardless of the cyclical positioning. Policy rates remained negative for twenty years in real terms, dictating their "guidance" to the markets.

The reason for this stimulating obstinacy? Inflation was below the 2 percent target set by the central banks. Achieving such an objective--which is obviously arbitrary and cannot be equated with the economic optimum--should never have been the single and absolute guide for policy.

For a number of reasons, break-even inflation (which prevented both deflation and excessive inflation) had been around 1 percent. And it is this, insignificant, disparity that "justified" the ensuing debauchery of monetary creation.

The consequences were of immense severity, which few observers denounced. First, the prolonged existence of zero or even negative rates has been disastrous. It has exacerbated the search for yield, propelling the value of junk bonds, stock exchanges, and most financial assets beyond reasonable limits, thus preparing for the severe adjustments that will follow the inevitable corrections to come.

This policy has allowed our world to accumulate the most phenomenal global debt ever observed in peacetime, with all the vulnerabilities it entails. It has also been accompanied by an extraordinary increase in income inequality.

Has the abundance of zero-rate liquidity at least promoted productive investment? No. In a system in which savings are no longer remunerated at all, economic agents prefer to keep riskless liquid...