There’s a revolution going on in the central banking world.
When the cult of independent central bankers took hold, their main enemy was inflation. They all had to keep inflation rising at a gentle pace of around 2% a year.
They didn’t care about asset price inflation. The price of a house could rocket as much as it liked. And they were quite relaxed about the soaring price of energy as long as this was offset by a drop in the price of music players, for example.
All in all, they managed to stick to the inflation target pretty well. Meanwhile the economy still overheated massively, then collapsed in on itself under the weight of all the debt everyone had taken on.
That approach clearly didn’t work. So what’s the new recipe for success?
The Federal Reserve in America has thrown caution over inflation to the winds. It is now emphasising employment over price changes. The Fed has become even more aggressive in its monetary policy, even as the US economy seems to be healthier than it has been in a long time.
In the UK, the Bank of England governor-in-waiting, Mark Carney, says he’s a fan of NGDP targeting.
In short, it means you target a certain level of nominal economic growth. If that means tolerating inflation at 5%, while ‘real’ growth is at 0%, then so be it. In other words, it’s a way to go soft on inflation without breaking your rules.
And in Japan, the new party in power has sworn to stop deflation. The Bank of Japan may end up with a new inflation target of 2%, double its current target.
In short, central banks have decided that inflation doesn’t matter anymore. Fretting about this target is holding them back from taking the decisive action needed to resuscitate our ailing economies. 2013 is going to be all about taking monetary policy to the max.
We sense disaster looming.
Central banking might just work, if it was genuinely independent. If you had central bankers who were willing to do the whole ‘counter-cyclical’ thing, we might have a more stable economy.
In other words, if central banks were willing to raise interest rates to temper booms, rather than just slash them to alleviate busts, then they might do some good.
But this is never going to happen. Central banks argue that it’s impossible to see asset bubbles inflating. This is nonsense. The fact is that they don’t care about bubbles.
All that matters to them is that the economy keeps chugging forwards. It doesn’t matter whether it’s chugging towards the promised land or towards a cliff edge – all growth is good growth. So they will never act to rein in a boom, regardless of whether it’s ‘healthy’ or not.
This is because central banks are political institutions. They are not independent. And as long as you understand this, then it’s easy to see why we’re trapped in this self-destructive cycle of bubble-blowing.
Politicians will always pursue ‘boom and bust’ policies because they always think they’ll get out on time. Voters love a boom. Taking the punch bowl away during the boom time is not the way to win votes. And by the time the bust arrives, it’ll be someone else’s problem, with any luck.
This central bank bias in favour of ‘easy’ money lies at the heart of all the bubbles we’ve seen in recent decades. The tech bubble inflated, then burst. Interest rates were slashed. The property bubble inflated, then burst. Interest rates were cut to near-zero, and central banks started buying government bonds. So we now have a bubble in government debt.
There is one thing that is more toxic for bond prices than anything else – inflation. And right on cue, across the world, central banks are falling over themselves to abandon inflation targeting.
Is there a method in their madness? Or are they just pursuing growth at any cost? Past performance is no guide to the future, we’re always told. But I think anyone who believes that central bankers are going to get it right this time is being almost deliberately naïve.
So what can you do about it? A bond market blow-up would be nothing short of disastrous for most asset classes. We can’t know when it’s going to happen. But it’s one good reason to make sure you have a well-diversified portfolio.
John Stepek
Contributing Editor, Money Morning
Publisher’s Note: This article originally appeared in MoneyWeek
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