The central banking revolution will end in disaster

Investing these days increasingly feels like living on the slope of a massive, active volcano.

You go about your day-to-day life, scratching an existence. At the back of your mind, you’re constantly aware of this grumbling, belching behemoth in the background. But you try to ignore it.

The tribal shamen, Ben Bernanke and Mervyn King, reckon there’s nothing to worry about. Of course, the last few times they said that, the volcano promptly erupted and buried half the village in molten lava and burning ash.

But they’ve got some great new ideas up their sleeves about how to appease the volcano. Surely they’ve learned from their mistakes by now?

Sadly, we doubt it…

Central bankers are throwing caution to the winds

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. You can read more about this from my colleague Seán Keyes here: Should we replace Mervyn King with a robot? 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 any more. 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 banks have a bad record – why trust them now?

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.

We’ve been knocking about some ideas for setting up a long-term, cheap-to-run, core ‘retirement’ portfolio at MoneyWeek recently. We’re looking for something that allows you to sleep at night without sacrificing a big chunk of performance.

We’ll have more details on this in the New Year, but it’s certainly made me think a lot about how investors can survive and even make money with this potential disaster looming in the background.

Loosely speaking, I’d suggest having some money in cheap stocks (Japan in particular – see here for more), very little – if any – money in bonds (except perhaps index-linkers), some gold, and a decent amount of cash. The cash is there to give you the opportunity to snap up cheap assets if and when the bubble finally bursts.

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23 Responses

  1. 17/12/2012, Bob wrote

    Excuse me for being a bit thick on this… and I note that you write “We can’t know when it’s going to happen”… but is there any idea of a ball park figure here?

    6 months? 12? Two years? 5 years? Sometime in the next decade? Keeping a lot in cash for a decade in the current climate would be a disaster.

    I also am not clear on why the bond market will blow-up – is this because people stop buying bonds? But who are these people? I thought the main buyers of bonds now were central banks engaged in money printing? So aren’t they just going to keep printing and buying each others bonds?

  2. 17/12/2012, DW wrote

    John Stepek is one of the best financial journalists in the country. Compared to many of the other voices out there, his thoughtful analysis is spot on. In this article, he restates an earlier theme — hold some cash in readiness for the major buying opportunity that is on its way.

    Given the state of the world economy, I’m pretty sure he will be proved right.

  3. 17/12/2012, Grant O wrote

    The Australian Reserve Bank has arguably done a good job of being counter-cyclical over the last couple of decades. Certainly they have not been afraid to lift interest rates at times that do not suit the incumbent government in order to try and contain the economy when it overheats.

    I think the problem is more nepotism and cronyism in the financial communities in London, New York and other major centres. Here the idea of independence seems to be much more elusive, and asset price bubbles tolerated (they surely know they are happening) provided that the “right” people are making money out of them.

  4. 17/12/2012, Brian wrote

    For anyone who believes we ever had an independent Bank of England.

    Listen to the man who said he was making the B of E independent back in 1997

    Listen to Gordon Brown speak at the London School of Economics in December 2010:

    http://www2.lse.ac.uk/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=834

    From about 7.5 minutes in………

    If you can take that much of that arrogant a….

  5. 17/12/2012, Postkey wrote

    “In other words, if central banks were willing to raise interest rates to temper booms, . . . “

    This what M.K. had to say.

    “The period prior to the crisis was the most stable economic environment for generations. And, unlike most previous recessions, this crisis wasn’t preceded by an unsustainable boom in output. In the five years leading up to the crisis, overall GDP growth remained close to its long-run average and inflation differed from the 2% target on average by only 0.2 percentage points. Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.
    To argue that monetary policy should be directed to counter inadequately priced risk is to argue that unemployment is a price worth paying to tame the banking system.”

  6. 17/12/2012, Despondent wrote

    It is interesting to read all the doom and gloom about inflation, QE and all that stuff.

    The over arching solution appears to be growth.

    This cannot work in the long term.

    The Earth is not getting any bigger.

    We need to stabilise then reduce absolutely everything: population, commodities usage, energy and water consumption, etc.

    Is there any hope of anyone actually acknowledging the long term folly of current policies?

    I doubt it – there is far too much short term vested interest.

  7. 17/12/2012, simpleton wrote

    Central bankers are morons in the extreme. They have now gone and blown the most dangerous bubble of the lot – a bond bubble. In answer to Bob 1) there is only one way out of the predicament that over-indebted countries find themselves in – inflation, and lots of it; it is the only way to erode the debt, to allow growth to resume. It is evident that central banks are choosing this route over the deflationary bust that should have occurred. If inflation takes off you don’t want to be left holding bonds whose real yield is eroded by the inflation rate (yields are already negative in many cases). And if the central bank tries to buy up all the bonds that no-one wants, the currency will suffer as it becomes obvious that the bank is just printing to fund borrowing (it’s already buying 30%+ of all new gilts). So it’s bond market collapse or currency crisis and a slim chance of navigating a skilful course through these particular rocks.

  8. 17/12/2012, Stephen wrote

    ng time perhaps decades. All the while it is the citizens who will suffer continued and unrelenting impoverishment.

    Only way I can see the above not happening is if people wake up and see the 2 (or 3 – whichever you prefer) party system for what it really is and always has been and get a party in that will hopefully do the right things. So its mostly a political change that is needed otherwise just put all your money into hard assets especially gold and wait it out!

  9. 17/12/2012, Despondent wrote

    Buy Gold? Is this not another uncertain thing to do? Better than holding cash perhaps, but if one or two of the major gold hoarding countries decided to sell their thousands of tons of the stuff for dollars and buy up all the real estate (especially farm/food production land, for example) that they could find what would happen? Gold would fall and real estate would rise – similarly for other physical assets that they could choose to buy.
    Perhaps the only way out is to go back to the Middle Ages and barter everything: goods for goods. Trust no paper or “useless” commodities like gold.

  10. 17/12/2012, Jack wrote

    Since no one wants to borrow the money that the central banks are injecting into the banking system, how is inflation going to take off? The money isn’t going into circulation, its velocity is practically zero.

    Real interest rates are artificially low, they cannot go down, so they must go up. This might be achieved by deflation producing a negative RPI. Why wouldn’t this scenario occur?

    Lots of commentators have suggested the recurrence of inflation, but I await an analysis of why deflation won’t win. I also await an analysis of what happens if deflation does win.

  11. 17/12/2012, Stephen wrote

    @ Despondent – I admit gold is risky but it is unfortunately prevailing in the minds of of a lot of the old ‘conservative’ types who are not fooled by what the governments are doing. It’s a shame really since there are better ways to put their cash to, but it doesn’t help when you have an array of gold bugs on the web telling us that the only way we can beat corrupt governments is to buy gold and silver.
    Perhaps instead they should be advocating another way out that precludes gold and silver, most people came late to the gold-party anyway and it is time to shun the barberous relic.

  12. 17/12/2012, FrostyA1 wrote

    What we`re missing here is that if the `poo hits the rotor` all investment will be nullified & worthless. You can sod about shifting bonds to gold, then gold into undervalued Japanese,Italian, & Tiger stocks, or cash under the mattress, but the end result will be a 30`s style wipeout of personal funds & clever investments.
    By all means buy projected `rave` about turns on Tuesday if it makes you feel more secure, but if it all goes askew on Friday dont expect to be safe or secure.
    This fat,grasping World has to finally learn to live within it`s limited means, or leave one helluva mess for our kids to clean up.

  13. 17/12/2012, Reality Check wrote

    Basically we have two routes

    1) Either bond prices are allowed to collapse, causing a spike in interest rates and forcing anyone holding debt into default and asset prices fall and we can start again.

    2) Currency collapse causing domestic price increases and forcing everyone to stop buying all but the essentials in life.

    It seems pretty clear that the BOE has chosen to go for number 2. So expect continued money printing and bond buying forever!

    Understanding that this course is irreversible and inevitable now is the first stage in knowing what to do with your “cash”.

    IMV, you’ve got to own some previous metals to protect against a heavily devalued stirling in the future. A good selection of dividend paying stocks whose earnings are likely to benefit with rising prices. I would also have a diversified selection of investments in countries who do not have the debt problems of the west and whose currencies will be the winners against an ever weakening pound.

  14. 17/12/2012, China Watcher wrote

    Only China’s central bankers are doing their job properly. Their counter-cyclical measures are spot on, while those in the West only go one direction. That it loose, more loose, and print print print…

  15. 17/12/2012, S. D'Souza wrote

    10, Jack -As far as i have understood, the BoE is printing in order for the government to pay its bills as tax receipts are diminishing and in the absence of growth it is only getting worse day after day. So, when the government pays the bills through this unbacked/fictional money, the inflaation does eventually enter the public domain albeit slowly. In effect it increases the money supply disproportionate to the goods and services which most certainly will cause inflation in the long run. Even if there was not another financial tsunami to push us back into a collapse in the next few years, the current government trend is an assured slow decay of the country.

  16. 17/12/2012, chris wrote

    Surely all these Harvard and Oxbridge educated men could not possibly be so incompetent in their chosen subject? No they could not. Being a bit of a conspiracy theorist i would suggest that they are actually deliberately trying to trash their own system in order to have the excuse to replace it with something else.

  17. 17/12/2012, Bob wrote

    7. simpleton – thank you.

  18. 18/12/2012, panserbjørne wrote

    Abolish central banks

  19. 18/12/2012, Gollamudi wrote

    I think the US and UK need to send their central bankers to the Reserve Bank of India for training. Our bankers are not that glamorous nor do they have the pay packets of a Carney but they are so stolid and boring that the markets in spite of getting themselves into a tizzy expecting a rate cut todaywere disappointed. In fact the RBI told the Govt to shove off in a burst of newly discovered independence, forcing the finance minister to grumble that he will have to go it alone.

  20. 18/12/2012, Ideas Man wrote

    Despondant is right in both comments.

    Here are my thoughts… inflation starts to rise and the difference between interest rates on bonds and inflations means the total value of bonds hold are decreasing…

    So, best to sell off and invest in another higher yielding investment such as property, stocks, or lending to business.

  21. 19/12/2012, smlaing wrote

    It was always coming. It’s clear what they want.
    Right now we have 1% interest on 5% inflation. Things are not moving fast enough for them. What they want now is 10% inflation and 4% returns. The dumb money will think this is great. The smart money will yawn with bordem. This will be catastrophic for for existing money but great for debt destruction.

    As always, It’s the same old, same old, same old. Nothing new here. What will happen is inflation will get out of control because of inflation expectations, and they will let it happen.

    Please wake me up in 10 years when a loaf is a tenner, milk a fiver, 80% of the middle class live in tenements and an ounce of gold is £10k.

  22. 19/12/2012, smlaing wrote

    As for the defaltion argument. There no point printing money if it can’t be spent. Right now it is finding it way into overseas assets thus inflation is much higher elsewhere. Eventually it will take hold here. Remember, history shows us that there has never been a deflationary bust in a debt based fiat monetary system. You can also be assured that Central Banks will never let it happen!

  23. 20/12/2012, IJ wrote

    So much groupthink here. Some of you really need to ask yourselves: what if the central bankers are right, and i am the moron?

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