The Lords of Money Pose Massive Threats to Markets

The Fed failed to stem inflation because it spent too long looking to the past, as part of its policy of being “data driven,” and so kept rates too low for too long. By sticking to the data-driven mantra, it risks repeating the mistake in the opposite direction, raising the chance that it causes the next recession and has to do a 180. Since the markets have barely begun to price in a recession and so a fall in earnings, that would hurt.

On Wednesday, Fed Chairman

Jerome Powell

went even further, saying he wouldn’t “declare victory” over inflation until inflation has been falling for months. Since inflation typically peaks right at the start of a recession or after it has begun, this makes it hard for the Fed to stop tightening.

Mr. Powell talked about finding out empirically what level of interest rates slows the economy enough. My read of that is that the Fed has committed to keep hiking until something breaks.

The European Central Bank has a familiar problem: politics. On Wednesday the ECB held an emergency meeting to address the problem of Italy, and to a lesser extent Greece. The ECB wants to damp down the rising heat in Italian bonds, where the 10-year yield rose to 2.48 percentage points above Germany’s before falling after the ECB action.

Unlike a decade ago, when the then-ECB head and now Italian Prime Minister

Mario Draghi

pledged to do “whatever it takes,” the central bank’s action has come before a fire breaks out, which is commendable. But the interim measure of redirecting some of the maturing bonds bought as pandemic stimulus into troubled eurozone countries is relatively small.

The ECB promised to accelerate work on a new “anti-fragmentation instrument” as a long-term solution, but here’s where it runs into politics. The rich north has always demanded conditions in return for shoveling money into troubled countries, to ensure they don’t use lower bond yields as an excuse for yet more unsustainable borrowing. But until the flames are engulfing the economy, troubled countries don’t want the embarrassment—and political catastrophe—of accepting oversight from the International Monetary Fund or the rest of Europe.

It will be hard for the ECB to buy bonds in Italy to keep yields down at the same time it raises interest rates elsewhere. At the very least, it will have to impose tighter policy on other countries than it otherwise would. At worst, it will be taking on the existential risk that Italy might default one day, as Greece did, crushing the ECB’s own finances. Both are politically toxic.

At the moment Europe’s inflation problem is different to the U.S., as wages are not running wild. But if Europe follows the U.S., rates might have to rise so much that slow-growing Italy would struggle to pay interest on its government debt, which stands at 150% of gross domestic product, no matter how much the ECB compresses the Italian spread over German bonds.

Even a small risk of Italy running into trouble justifies dumping its bonds, as higher yields become self-fulfilling. When higher yields increase the risk of default, they make the bonds less attractive, not more attractive. Left to itself, the market would keep pushing them up in an endless spiral.

The Bank of Japan is also fighting the markets, although it has a better chance of winning than the ECB. Investors have been betting that the

BoJ

will be forced to push up its cap on bond yields, known as yield-curve control. In principle the BoJ can buy unlimited amounts of bonds, so it can maintain the cap if it wishes. But if investors thought inflation justified higher yields, the BoJ would have to buy ever-increasing amounts of bonds, since investors would not want them, as the late economist Milton Friedman pointed out in 1968.

Japan has the best case of any major developed country for easy monetary policy. While inflation is above 2% for the first time since 2015, it is almost all due to higher global energy and food prices, and there’s little pressure for higher wages. Exclude fresh food and energy, and annual inflation was 0.8% in April, hardly a reason to panic.

Still, inflation is up, and the risk is growing that the BoJ has to give in, leading to a step change in bond yields—the sort of shift that can rip through markets globally. When the Swiss central bank abandoned its currency ceiling in 2015, several hedge funds that had bet it would stick to its guns were hit hard, and some were forced to close. Japan is many times more important than Switzerland, which itself roiled currency markets in the past week with an unexpectedly hawkish rate rise that led to a big rise in the franc.

This gloom might all be avoided—central banks are pretty smart. But major mistakes are more likely than they were, which means the risk of extreme events in the markets is rising. That calls for caution on the part of investors.

Write to James Mackintosh at james.mackintosh@wsj.com