Market Thinking

making sense of the narrative

After a year of bad policy, the risk is that the Central Bankers say ‘hold my beer’

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The dirty little secret of Monetary Policy in much of the west is that it has actually long been really a form of fiscal policy. When you have a population with large amounts of floating rate debt, changing the cost of financing that debt is effectively the same as directly boosting or shrinking disposable income. Raising interest rates means mortgages effectively crowd out other expenditure, while lowering them acts like a tax cut and boosts discretionary spending. It has also allowed for greater leverage to be taken on as interest rates reached zero.

Unfortunately, history shows that most academic economic ‘experts’ are as computer-model obsessed as their counterparts in the Climate and Covid worlds. Failure of the real world to conform to the models is either ignored or ‘fixed’ by inserting so many dummy variables into the computer model that it is ‘correct’.

This then is the biggest short term risk to Economies and Markets, that Central Bankers believe their models and raise interest rates to ‘fight inflation’ and deliver the very stagflation that they wish to avoid. In effect, after the disastrous Zero Covid policies of lockdown have distorted the global supply chain and the equally disastrous Zero Carbon policies of unreliable renewables are threatening a winter energy crisis, the Central Bankers step in with a “hold my beer’ moment and really, really mess things up.

Hold My Beer... - Military humor

Why Raising Interest Rates is exactly the wrong thing for most central Bankers to do right now.

Back in the last century when I was running economic models forecasting the economy for a major bank, I would often say that the models were like sausages – if you knew what went into making them you probably wouldn’t touch them. It’s not that they had no value, rather that they were analytical and diagnostic tools being incorrectly used for making predictions – and thus, unfortunately policy. Of course, forecasting what the other forecasters were going to say had a lot of value in markets, especially when policy makers acted on the advice of these ‘experts’, but as we have noted on numerous occasions, no sooner had economist John Taylor distilled the components of the Fed Model, sometimes called the Taylor Rule, in the mid 1990s to predict Fed Policy on the basis of high frequency data, than the Fed stopped following the previous rules! This hasn’t stopped the ‘sports betting’ approach of the rates markets in predicting and reacting to the non farm payrolls, but the reality is that since the mid 1990s, economists ceased to be regarded as ‘experts’ and largely a good thing too.

They had a brief resurrection after the GFC when clever publicists like Nuriel Roubini claimed to have predicted the crash (he didn’t) but was welcomed by an establishment looking for direction as well as retribution on the bankers. (Perhaps no surprise ‘Dr Doom’ is calling for higher rates now). At that point everyone was blaming the GFC on the housing market boom rather than the derivative bubble built on the back of it – it only required a small, economically minor, drop in house prices to bring the whole inverted pyramid of illiquidity crashing down. Forecasting a drop in house prices was not to forecast the collapse of the derivative pyramid that few people knew existed. The fact that the official response, cutting interest rates to zero and Quantitative easing has singularly failed to stimulate the economy or create inflation – as was its avowed intention – seems to have triggered little or no introspection. The real world has failed to follow the model, so the real world must be wrong! Similar puzzles around failed models have also failed to trouble the ‘inquiring minds’ in the Climate and Covd prediction spheres, where the current ‘experts’ reside, Zero interest Rates has been replaced with Zero Carbon and Zero Covid as a home for ‘experts’. But we will return to those in a moment.

A financial analyst – or franky anyone operating in the real world – would have noted that the impact on the economy of changes to interest rates is via existing cash flows as well as size of balance sheets. Sure, cheaper, but also more available, leverage will lead to too much money chasing too few goods and cause inflation and vice versa, but that is usually at the margin. The bigger impact is on disposable income after financing existing debt and given that most of the debt in the west is household mortgage debt, this means monetary policy acts like fiscal policy; a tax increase or a tax cut. Thus as rates were cut in the wake of the dot-com bubble, the housing sector in the west boomed as cash flow was boosted and the household sector expanded its balance sheet, especially in floating rate markets like UK, Australia, Ireland and Spain. In the US they had an important phenomenon of fixed rate but refinanceable mortgages, which meant the US household was able to benefit from lower rates but lay off the risk of higher rates, which meant that the historically observed US response to monetary policy was more muted – a point that policy makers missed when tightening policy in floating rate markets like Ireland or Spain. By the time of the GFC, the US had indeed become more rate sensitive, moving to cheaper and riskier floating rate debt, but lowering rates to zero while limiting the ability of households to expand balance sheets – even if they wished to- was never going to revive housing or boost CPI. The household sector has been deleveraging and therefore monetary policy has been neutered.

Here it would be worth observing the example of Japan. When rates were cut in the 1990s, Japan did not increase leverage and the consumer did not boom leading to inflation. This was a function of their balance sheets. Interest rates were the return on their assets, not the cost of their leverage. As any target date financial planner will tell you, if you halve expected return, people save more, they don’t spend more. In fact something similar happened in the west with corporate pension funds. As rates were cut, companies had to put more cashflow into pension schemes and less into investment or wages or dividends. If the economists had looked, they would have seen that not only did monetary policy not achieve what the models said, but in many cases it dd the opposite.

What lower rates did do of course was encourage the corporate and Financial sectors to increase leverage and drive inflation in the things that they are buying – financial assets, but that is for a different discussion.

The danger now is, that having failed to understand how zero interest rates do not stimulate the economy, the ZIRP practitioners are replaced by a different set who believe there is no downside to raising rates, given that now that they are worried about inflation actually coming through, as opposed to worrying why it wasn’t. They need to model the impact on disposable income based on household balance sheets as they stand now and factor in the impact on disposable income post higher prices on essential items and post pandemic tax increases. A long term econometric model that is based on post war US households and that assumes away all other impacts is worse than useless. It is dangerous.

There is a danger that, rather than a rotary dial to control the economy, the Central Banks think they only have an on/off switch

The problem we have right now then is that the consumer sector is being battered with higher prices for basic goods and services such that the Models at the central banks are flashing red. After years of trying to ‘stimulate inflation’ it looks like they have got hit with it. And hard. There is the old (and powerful) image of policy being like dragging a brick over a rough surface on a piece of elastic; nothing happens until the last tug frees the brick and it snaps to hit you in the face. Except of course that this inflation is nothing to do with the monetary stimulus, nobody has rushed out and increased their balance sheets, instead it is a supply side problem. A supply side problem caused by the latest set of ‘expert modellers’ – the ones that shut down the global economy on the back of Covid. Even as things open up, in effect the world is suffering from Economic Long Covid (ELC) as just in time supply chains remain disrupted and global logistics unable to function properly for essential items. At the same time, furloughs and border restrictions on movement of labour have compounded this short term spike in prices, while in Europe the other set of ‘experts’ promoting Zero carbon (as opposed to Zero Covid or Zero Interest Rates) have contrived to deliver failures to long term energy policy such that the most basic of goods are spiking in price dramatically and crushing disposable income.

Raising interest rates to try and stop inflation in the prices of basic goods and services is thus the surest way to stagflation and yet, supposedly intelligent Central Bankers are talking about it. It will do nothing to help with the supply shortages in essentials and simply crush demand for everything else. Thus once again, the biggest risk to economies and markets is dogmatic policy making that is based on theoretical modelling and takes little account of real life.

There is nothing so bad that politics can’t make it worse

Thomas Sowell
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