The central banking revolution will end in disaster

published 17 December 2012

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.

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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 Sen 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 nave.

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.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.