Inevitable Outcomes?

While last week was quiet in the markets, over the long term, I expect markets to be anything but quiet; central bank policies will see to that.

I have long been critical of central bank policies and, truth be told, I am fundamentally opposed to private bankers controlling monetary policy which is the case worldwide today. 

History teaches it never works in the long term.  To think that private bankers are putting the interests of the public ahead of their own interests is as unrealistic as it is naïve.

Thomas Jefferson, one of the founding fathers who understood this well, had a lot to say on this topic.  One of his quotes, becoming more famous due to present monetary policy rings true:

“If the American people ever allow private bankers to control the issue of their currency, first through inflation, then through deflation, the banks and corporations that will grow up around them will deprive the people of all property until they wake up homeless of the continent their Fathers conquered.”

Then there is this one, also attributable to Jefferson:

“I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.” 

While central banks, controlled by private bankers, still enjoy a fair amount of believability worldwide, the day is soon coming when the central bankers will be recognized as the cause of the problem rather than the solution to all things economic.

Francesco Brunamonti, writing for the Mises Institute had this to say in a piece he wrote recently titled, “Central Banks Are Just Getting Warmed Up” (Source:  https://mises.org/wire/central-banks-are-just-getting-warmed) (emphasis added):

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 sometime 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.

Some comments.

First, Mr. Brunamonti states that central bankers have ‘religious trust’; in the Phillips curve.  The Phillips curve simply theorizes that the relationship between unemployment and inflation is inverse.  In other words, when unemployment is low, inflation is high and when unemployment is high, inflation is low.

The Phillips Curve was first discussed by its developer Bill Phillips in 1958.  In developing this economic theory, he studied nearly 100 years of wage inflation and unemployment in the UK.  After his theory was introduced, it was met with skepticism by other notable economists such as Edmund Phelps and Milton Friedman who argued that wages would automatically adjust to the market on an inflation-adjusted basis.

Given that the official unemployment rate is very low as is the official inflation rate, that would seem to make the case for Phelps and Friedman’s argument.

The bigger point here is that central banks, as Mr. Brunamonti states, are regularly meeting to try to figure out new, ever-more innovative ways to stimulate the world economy.

Consider central bank actions since the financial crisis and you’d have to conclude that central banks are increasingly desperate.

Remember 10 years ago when the central bankers decided to engage in a program of quantitative easing, a.k.a. money creation out of thin air coupled with zero interest rates?  As Mr. Brunamonti correctly states it was to be a one-time, emergency measure that would never be used again.

Yet, despite the insistence that interest rates would return to more normal levels, it took only a couple of rate hikes to throw the financial markets into absolute turmoil.

Now, in addition to negative interest rates (not just zero interest rates), central bankers are continuing their program of quantitative easing although according to Mr. Powell, current Federal Reserve Chair, we are not to call it quantitative easing.

This latest decision to engage in quantitative easing (I don’t know what else to call it) came about so the Fed could prop up the repo market.

The repo market refers to repurchase agreements or the lending in which financial institutions engage among themselves.  Last month, the Fed injected cash into this market when the interest rate for overnight loans jumped from a couple percent to nearly 10%.

The Fed hadn’t been forced to put cash into this market in over 10 years, since the time of the financial crisis and the failure of Lehman.

There was never an official explanation given for the Fed’s latest foray into the repo market, but, reading between the lines, one would have to assume that there were banks worried about getting repaid on their short term loans perhaps because a big bank was once again looking shaky? 

This suggests that despite more aggressive monetary policy – negative interest rates and money creation – there are once again problems with the financial system.

Makes me wonder what money experiment central bankers might try next although I am very sure they will come up with something.

Regardless as to what the next money experiment is, Mr. Brunamonti has, in my view, stated the inevitable outcome of such an experiment. 

This from the article quoted above (emphasis added):

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.

The behavior of central bankers is not likely to change.  That means your investment behavior needs to change. 

You need to have a deflation hedge to protect you from boom and bust cycles and an inflation hedge to protect the purchasing power of your savings.