Central Banks Are Just Getting Warmed Up
According to all central banks, one of the main problems they are called to solve is that countries cannot reach their inflation target of (close to but below) 2 percent. Even their religious trust in the long-discredited Phillips curve cannot explain why price inflation is low in many countries despite historically low unemployment rates. Nonetheless, central banks still enjoy immense credibility. It’s common to hear such sentences as “never bet against the Fed,” the “ECB has big bazooka primed”… and all market participants monitor each public meeting to understand what the next policy could be and how they should be positioned when it arrives.1
To reach the inflation targets and “stimulate the economy,” central banks regularly meet to devise ever-new stimulus programs, and do not despair when, inevitably, the one-off unconventional interventions quickly become the new normal. For example, the world-famous Quantitative Easing (QE) was supposed to be a one-time emergency response to the 2008 crisis, except it has now become one of the many tools of regular monetary policy, and a key component in market demand for financial assets. An undesired but perfectly predictable side effect of QE is that it allows governments to increase their spending without care for the deficit, and still pay negative interest rates in real terms, so no discipline is imposed, except for some empty promise to reduce the deficit some time in the future, if the opportunity comes. Several Western countries have embarked in QE, some in many consecutive rounds, but there is no mention of a reverse-course, an eventual, opposite Quantitative Tightening (QT). Only the United States have tried QT, and the Fed has even announced that they were on a stable and data-driven process back to normalization, to try to maintain their reputation of scientific management of the monetary aggregates. However, the Fed had to quickly abandon the plan, and its balance sheet remains massively bloated under any historical measure. It is abundantly clear that markets are doing well only thanks to monetary life support, and the help provided by QE cannot be taken out without provoking a serious crisis across all the whole investable universe.2 Now the Fed has embarked in a new round of QE, although Powell denied in the most absolute terms that it is QE.
There is today a veritable alphabet soup of monetary policy tools (QE, OMT, TLTRO, APP, ABCP…) and the result is that no asset class is free of distortion, including the key markets of foreign exchange and corporate debt. All these tools are only more of the same: they apply the same means (create new money out of thin air) to reach the same end (artificially decrease the interest rate). Clearly these interventions have the same side effects as a regular, conventional decrease of the interest rate. Chief among these problems are a general hunt for yield in all markets, the setting in motion of boom-bust cycles, and the inability for pension funds to provide savers with a long-term real return to support retirement and future consumption. Far from being problems confined to banks and the ultra-rich, this diverts resources from savers and wealth generators to the politically-connected.
As historically low interest rates stifle growth and stimulate consumption but not production, it is easy to find throughout Europe and the US low wage growth, low investment for productivity growth, and growing debt burdens on governments, corporations, consumers.3
As always, central banks (like their politician friends) try to solve problems by doing more of the same. Both the Fed and the ECB signaled they're not finished yet: the ECB lowered its target rate again, and announced a new round of bond purchases. Meanwhile, the Fed lowered its target rate again, likely on the road back to zero.4 The latest trouble is in the repo market , where banks lend to each other overnight. The Fed has a target rate for interest rates in this market, but the rate skyrocketed well above the upper bound.5 The Fed stepped in and announced an emergency liquidity assistance (in common speak: bailouts) that will last for months, standing ready to provide print money at will. For a central bank that takes pride in announcing its interventions well in advance to prepare the markets, this is an unseen event. They moved much and quickly, signaling that the problem truly is important. The Fed balance sheet is growing again, and now there is one more moral hazard in town: liquidity risk is not a problem anymore, so the liquidity carry trade is much more profitable.6 Rest assured that if a liquidity crisis will happen despite interventions, nobody will blame the Fed. Possibly, they will claim the Fed had stepped in too lightly and must do much more.
Still new monetary tools may be tried in the future. All investors are speculating on what the new tools could be, one possibility is that the ECB (and possibly, in the future, the Fed) could follow the lead of the Bank of Japan in creating a new QE to purchase directly stocks and stock ETFs. Few people won’t be shaken reading a sentence as “The BoJ was ranked as a top ten shareholder in some 40 per cent of all listed companies”, but this is precisely the course of the monetary authorities. However, like all monetary interventions, this would prop up all markets into further bubble territory, while the endemic problems of the economy are never addressed.
Figure 1 - Data from TradingEconomics, Federal Reserve Economic Data
Now, what does the market think of all this monetary machinery? The central bank targets an inflation rate, so given its immense credibility the market should assume that the target will hit. Currently the inflation rate is below targets, but more troublesome (for the Fed) is that the market expects central banks to continue failing: the expected future inflation rate is on average “only” 1.6 percent in the US , 1.1 percent in Europe , 1.2 percent in Japan .7 It is thus unclear what this continuous intervention in money is good for, other than pumping up markets and kick the can down the road, pretending that since markets are up then the economy must be doing well.8
There are even talks about letting inflation run higher than 2 percent. This number had always been set in stone as the highest number allowed, with central banks standing ready to defend us from higher numbers. Eminent figures such as former IMF Chief Economist Olivier Blanchard have suggested to raise the inflation target to 4%, if not more. This would double prices (and halve savings) in about 18 years, less than a generation. So much for the Fed’s goal: “price stability”. But this is not yet generally accepted, and the current fashion is to claim that the inflation target is not 2% but “symmetrical 2 percent”: after years of undershooting we should have years of overshooting, so the long-term average will be 2 percent. In effect, the BoJ and then the Fed have pre-emptively announced that they will not fight inflation unless it becomes too high, without defining “too high”. This pushes a normalization even further in the future, as a price inflation of 3 percent, 4 percent, 5 percent would be allowed to continue for years, or until it becomes “too high”, but “too high” has not been defined.9 The ECB is likely to move in the same direction, especially considering the well-known dovishness of the new head Christine Lagarde.
As is clear from economic analysis since the Scholastics of five centuries ago, this lack of sound money and apparently infinite money printing does nothing but send confused signals, increase economic and legal uncertainty, and drive up the rates of time preference in a process of de-civilization and increasing present-orientation. The seeds of all crises since ancient times have been planted through distortions of money, and these concerted crusades of all central banks are no different. Fortunately, there are growing popular movements in Europe and in the United States to push towards a normalization of money and interest, and to restore sound money and free entrepreneurship. This is a process that started with the 2008 crisis, when we saw what happens after 40 years of monetary pumping: the long-run has arrived.
- 1. An example is instructive: many financial analysts suggest investors to purchase long-term European government bonds at negative yields, because they will profit as the ECB cuts rates into further negative territory. Say you buy a 10-year bond yielding -0.50%, and the inflation rate is 1.50%. If you hold the bond until maturity, you’ll have lost close to 20% of your initial purchasing power. Suggesting investors to make a quick buck by trading ahead of further ECB cuts is foolish at best, and a textbook example of the Greater Fool Theory: assume bond prices will always rise, then you can buy at any price because you are certain that you’ll find some other fool willing to buy at a yet higher price.
- 2. Hence several commentators now refer to current markets as the “everything bubble”: not a bubble in bonds, in stocks, in real estate, but in every asset class.
- 3. Hence the trillion-dollar government deficits and the skyrocketing trade deficits. For Germany, the problem is the opposite: its massive export sector depends on a continuous stream of purchases from abroad, but what happens when the buyers are already overleveraged?
- 4. This is a focal problem: commercial banks earn their revenue through the interest rate margin, borrowing from consumers at a low rate and lending at a higher rate. In a zero interest rate world the interest margin evaporates, and banking stops being a profitable activity, so lending is curtailed and the problems worsen, especially for overindebted corporations that can only finance their operations by rolling over the debt as it matures. This can the final nail in the coffin for European banks, and the ECB is desperate to find a way to avoid it, but we’ve had zero rates for 10 years now and no solution has been found.
- 5. Interbank repo interest rates go up because of two reasons: banks cannot lend (they do not have money), or they do not want to lend (they think other banks are not creditworthy). Either case is problematic, but either case is certainly possible. It is especially troublesome because these problems are happening in a time of unprecedented monetary pumping and hunt for yield, and the Fed wants us to believe that any borrower can easily find a willing lender, and that liquidity crises are a thing of the past.
- 6. A carry trade can be roughly described as closing an investment position to enter a new one with higher risk and higher expected returns. In this case banks can make their portfolio less liquid, to earn higher income (in expectations) but bearing liquidity risk. There are many different types of carry trade, but it is a recurring theme in financial crises that market operators had overextended their carry risks in some form.
- 7. Although the measure for inflation, the adjusted CPI, is an extremely flawed indicator. As for the GDP, it is an open problem to devise an accurate measurement of inflation.
- 8. Most economists claimed that this monetary morphine was a great way to buy time for governments to reduce their debts before the normalization, but it clearly was a most naïve wishful thinking. Even then, if the unprecedented money pumping succeeded in raising inflation rate to 2% from, say, 1%, this could scarcely be called victory. The only result would be a further Cantillon-effect redistribution of wealth from creditors to debtors, with indebted consumers (in the US) and profligate governments (in the US but mainly in Europe) being thankful. Savers and groups on fixed income will be left with the bill.
- 9. And even if inflation really picked up, the main tool to fight inflation is to increase interest rates, making new debt issues more burdensome. What is the likelihood of a Volcker-style rate hike when most countries have debt burdens above 100% of GDP? Letting inflation run its course would be more politically beneficial for a simple reason: it is easy to find scapegoats for inflation, but if interest rates were hiked the debt burden would increase immensely, and governments would have to massively raise taxes. Politicians would certainly not cut spending and take responsibility for what has happened in the past 30 years.