I’ve come to the realisation that central bankers, rather than being paragons of economic rationalism, are actually human beings. They are subject to the same behavioural biases as the rest of us, and make decisions in this context.
One of the more significant biases that affects decision-making is loss aversion. We all experience losses more intensely than gains and will react to the prospect of a loss more intensely than the hope of a win. This partly explains observed patterns in the stock market, which are often subject to rising trends and sharp falls. As markets go lower, investors tend to switch their focus to potential losses, which have greater emotional impact than the prospect of gains, and they head for the exit in a panic.
This loss aversion also drives an asymmetry in policy-making by our central bankers. There is a greater tendency to cut rates when growth is softening, rather than hike rates when it looks strong. Policy rates also tend to drift up and then drop sharply. Mirroring the behaviour of households in line with our “animal spirits” isn’t necessarily a bad strategy, but it assumes that monetary policy is an effective means of driving growth.
The real influencers of growth
Monetary policy is a pretty blunt means of influencing growth, but it turns out to be a very effective way of influencing asset prices. The notion that interest rates act like an accelerator pedal for the economy is misguided. Rather, economic growth is driven by population growth and productivity. Population growth is straightforward to measure, but productivity is an amorphous concept and more of an outcome of growth rather than something that can be measured directly on a bottom-up basis.
The real underlying drivers of growth stem from the structure of the economy. This includes such factors as the knowledge and skill built within corporations, the provision of public infrastructure, educational and training systems, legal and regulatory frameworks (that determine how individuals interact with businesses and how rights are protected), technological development and most importantly, entrepreneurial risk taking.
In recent decades, a lot of focus has been placed on microeconomic reform to improve the structure – and hence the growth potential – of the economy. However cutting interest rates doesn’t improve the basic foundations of growth. In fact, most economic theory tells you that allowing the market to act freely and the price mechanism to allocate resources is the best way to drive growth. It is not clear how fixing the most important price in the market, being the price of money, is meant to improve the allocation of resources and growth. Governments have more power to drive growth than anyone, but in the interest of political expediency they have abrogated policy responsibility to central banks.
Monetary policy works largely by shifting growth not creating it. It can bring consumption and investment forward from the future or by pushing down a country’s currency; it can steal growth from a trading partner. Changing interest rates can influence a company’s cost of capital and impact investment decisions, but as we’ve seen, high interest rates are much more effective at stopping investment than low ones are at encouraging it. The current era of low interest rates mainly serves to drive asset prices higher and stimulate debt accumulation in the economy.
The inherent biases in decision-making create an asymmetry in policy responses which means that debt is rarely reduced in good times. Increasing leverage leaves the economy in a more fragile state and more susceptible to economic shocks. Lower structural interest rates are then required to support a more leveraged economy. As central banks have run out of scope to cut rates, they’ve used QE to drive more leverage and boost asset prices.
The downside of a low interest rate cycle
The world is now caught in a policy trap. Low interest rates have some material negative consequences. They encourage debt accumulation for asset price speculation over productive investment decisions. They create social discord by concentrating wealth.
Those with assets appear to benefit from increasing wealth, but as returns are being suppressed, their income-generating potential is unchanged. With low returns on offer, the asset-rich are less likely to consume their capital gains because it will negatively impact their income potential. Those without assets face an uphill battle to accumulate them, with negative real interest rates and a higher proportion of their salary required to purchase the future income stream of an asset. Asset price growth that isn’t supported by profit and income growth is just playing with numbers.
It is hard to see what breaks us out of this cycle, but I don’t think the central bank goal of higher wage growth and inflation is what we should all be hoping for. The objective seems to be to have higher inflation so that real interest rates are even more negative, which will allow households and businesses to steadily deleverage and make the economy more stable. However, negative rates encourage people to gear up and speculate.
If the economy is actually doing well and real interest rates are becoming more negative, then historically these are ideal conditions to grow some destabilising speculative price bubbles.
Where to from here for investors?
How should investors approach this environment, where it is impossible to get a positive real risk-free return?
Unfortunately, the choice is to give up on wealth creation and live in the moment, or take on risk. Taking on risk is also problematic, as central banks are now the most dominant factor in asset pricing rather than growth and inflation. All asset prices have been driven higher – from bonds, to equities, to credit and property. As such they are now all correlated, the historic negative correlation between bonds and other assets that has driven risk-parity returns is unlikely to hold in the future.
It is easy to be bearish given the current policy quagmire, but growth is not unreasonable and I’m also happy to back human drive and ingenuity. The equity market is still offering positive real yields with growth potential. Equities, real assets with good yields, and genuinely diversified asset classes seem to be a better choice than the certain loss of purchasing power that comes from cash while central banks are such firm supporters of asset prices.