The wave of criticism of central bankers hasn’t let up in October with a Barron’s article arguing that central bankers are the truly scary clowns. Politicians have joined in the criticism with Theresa May and Donald Trump calling out the negative impacts of current monetary policy. What has changed is there is something of a fight back based on the concept of central bank independence. I’m a strong supporter of central bank independence, but a strong critic of central bank incompetence. Central bankers that ignore the obvious evidence of asset price bubbles and yield chasing, created by their ultra-low interest rates and money printing, should be sacked just like any other underperforming employee. The questions are who will replace them and what monetary policy should be targeting.
The primary central bank target is typically an inflation level of around 2%. There can also be some vague targets for stable economies (not too hot or cold), economic growth and/or unemployment rates. These add-on targets are unrealistic as central banks are limited to interest rate settings and control of the money supply. These two levers can help to control inflation, but by focussing on trying to boost economic growth central bankers have created instability in financial markets and economies. Truly independent central bankers would have stopped lowering interest rates long ago. They would have told politicians to implement structural and productivity reforms that will help lift economic growth rather than running Frankenstein experiments with interest rates and money printing.
What then should central banks target? The primary focus of central banks should be to ensure that inflation does not exceed a specific bound. The economic and social destruction caused by inflation has been shown in Weimar Germany, Zimbabwe and Venezuela. However, the idea that inflation must be positive should be dispensed as there is no evidence that small levels of disinflation are a problem at all. If your goods need to be replaced, will you go without for long periods simply because they might be 1% cheaper in a year? Even when disinflation is occurring, it will typically be as a result of excess capacity in an economy. Most often this overinvestment originates during boom periods when interest rates are too low.
The arguments against disinflation primarily revolve around debt, as inflation theoretically makes debt easier to repay and disinflation grows the real (post-inflation) amount owed. That argument is both morally wrong and naïve. It’s naïve as when inflation is high investors will usually demand higher interest rates to cover the value lost to inflation. It’s morally wrong as the right way to deal with excessive debt is to face up to it. Excessive debt should be restructured, with the debt owners given the equity in the business or the assets in exchange for reducing or eliminating the debt. If it’s government debt, then investors will suffer for their stupidity in over-lending to governments. There may be some out of jurisdiction assets available to be sold, but government debt effectively ranks behind the provision of services and pension obligations to ordinary citizens.
That all points to central banks being tasked with the job of keeping inflation below 3%. I’m comfortable without a lower bound, but some may choose to say the inflation should be kept in a range between -3% and 3%. To incorporate an economic stability element and to prevent financial repression central banks should also be required to ensure that the reserve rate allows all citizens to receive a positive real rate of return. This can be expressed as:
Independent central banks should embrace this rule as it will stop governments from implementing financial repression to deal with budget deficits. It would also deal with the arguments that low interest rates have worsened wealth inequality.
The need to change the committees that set interest rates is also necessary. Some academic economists can remain, but market practitioners who can observe the impacts of rate changes must be brought in. A greater diversity of views is also necessary; there should be voices on the committees drawn from those who are arguing that current rates are way too low. The groupthink amongst the current members at major central banks must be changed if we want to end the cycle of bubbles created by central banks setting interest rates too low for too long.
The arguments by central bankers and academic economists that central bank independence is being threatened is a smokescreen to cover incompetence. Ultra-low interest rates and money printing have created another asset price bubble following on from the tech bubble in 2000 and the sub-prime bubble in 2007. The targets for central banks must change if we want to end this cycle of bubbles. We must lose the false fear of deflation, ensure that citizens receive a positive real rate of return and end the groupthink amongst interest rate setting committees.
Written by Jonathan Rochford for Narrow Road Capital on October 27, 2016. Comments and criticisms are welcomed and can be sent to firstname.lastname@example.org
Narrow Road Capital is a credit manager with a track record of higher returns and lowers fees on Australian credit investments. Clients include institutions, not for profits and family offices.
Terrific piece Jonathan - could not agree more with the comments re disinflation!