In August, Federal Reserve Chair Jerome Powell warned that bringing inflation under control would mean ‘some pain’ for the economy. But how much exactly?
A crashing stock market wasn’t enough. Neither was a bear market in bonds. Nor an energy crisis. The supply chain debacle didn’t make central bankers flinch. Nor the war in Ukraine.
You might think the answer is that central banks will keep tightening monetary policy until inflation comes back down, whatever the pain. But you’d be proven wrong already. One after the other, central bankers are exposing that financial stability has priority over inflation. As soon as there’s bad enough trouble in financial markets, central banks go back to their old ways of spending their unlimited amount of money.
In Japan, a currency crisis was enough to get the central bank back in the market. In a big way too. The Bank of Japan spent US$19.7 billion on boosting its currency in September. Expensive, even for those who can print money.
Of course, the Bank of Japan can’t print US dollars or other foreign currencies — what it needs to prop up the yen in foreign exchange markets. Indeed, creating more yen would only weaken it further. And yet, the central bank is also active in Japanese Government bond markets. It is trying to peg the Japanese Government’s borrowing costs down.
This creates a bizarre game of Twister, with the Japanese central bankers tying themselves in knots. The Bank of Japan is printing money to keep Japanese bond yields down, which makes the yen fall, and then the Bank of Japan is spending reserves to bid the yen up again…
Central bankers never learn that every intervention has a side effect — a pressure valve that reveals the flaw in the intervention.
Anyway, it seems that a crash in the yen and a surge in government bond yields is enough to get the Bank of Japan to ignore rising inflation and prioritise the faux functioning of financial markets under their tutelage. There are now days when no Japanese Government bonds trade in markets…
In the UK, the Bank of England actually allowed bonds and the pound to crash before intervening. But intervene it did. Only days after announcing its intention to sell-off its bonds, it was right back to buying them…
The stimulus, if I might call it that, for the intervention was a 5% drop in the pound at one point, and a 60% drop in some UK Government bonds since December. Several UK pension funds would’ve been in deep trouble if bonds hadn’t recovered the day the rout was at its worst. And so, the Bank of England made sure they did, by buying them.
The market believes it has found the central bankers’ pain threshold. We now know when exactly central banks will change their mind about tight monetary policy. What it takes is trouble in the government bond and currency markets.
So now, the bailouts are back and it’s boomtime for stocks.
Cue a face-ripping rally in just about every asset for two days.
But the hope didn’t last long. The issue with crises in currency and bond markets is that they’re temporary and don’t bring down inflation if you resolve them.
We’re back to where we were before the crisis in the UK. With inflation too high and central bankers on the warpath.
Unless there’s a meltdown in government bond markets every two days, what prospects does the stock market have of rising?
What we need is the sort of ‘pain’ that actually brings inflation down. Not just tumult in currency and government bond markets.
Historically, this tends to mean unemployment or a crisis in the property market and banking.
Sure enough, mortgage pain is surging around the world. Credit Suisse is wobbling. And the US jobs market recently weakened, if from a very tight level.
So things might be looking up…or is it down? Is down up, at this point?
Welcome to the bizarre world of central bank-controlled markets…
There’s a bizarre irony here. Two, actually. Well, two I’ll mention for now…
First of all, if central bankers act to prevent a financial crisis from unfolding, as they have in Japan and the UK, then we may never get the drop in inflation that such a crisis tends to cause.
If a financial crisis in currency and government bond markets is so dangerous that it cannot be allowed to take hold of the economy and financial system, then how is it going to bring down inflation?
Such a crisis should, for example, force austerity on governments. If they can’t borrow cheaply, they need to cut borrowings. Less government spending has a deflationary effect, which would solve our inflation problem.
But if the central bank is back in the government bond market at the slightest sign this might actually happen, then why cut government spending and borrowing?
Heck, the earlier and worse your signs of an imminent sovereign debt crisis, the faster we can get back to printing unlimited amounts of money again because the central bank will be forced to finance it.
This incentive is especially bad in the Eurozone, but let’s not go there today.
The Bank of England’s about-face and the Bank of Japan’s pre-emptive strike on the bond market are so important because they give away the level at which central banks change their mind about loose monetary policy. How much pain it took.
Just as the pandemic was an excuse to spend and borrow like mad because the central bank would pick up the tab, so too is the threat of a sovereign debt crisis. The central bank will be forced to pick up the tab for that too. Or let governments go bust…
The second irony is that governments are making inflation worse with their attempts to deal with the energy crisis, especially in Europe. They’re subsidising energy consumption with fiscal policies. They’re spending more on energy infrastructure. They’re forcing industry to cut energy demand, which will create shortages in key goods, such as industrial metals and chemicals.
The knock-on effects will be more inflation, especially in food prices, as energy consuming greenhouses shut down and fertiliser becomes unaffordable.
The conclusion, if you agree with all this, is increasingly bizarre. We need the sort of financial and economic crisis that brings inflation back down again. Otherwise, there’s no monetary fuel for a market rally. Not on a sustainable basis, anyway.
If central bankers fight fires before they burn down houses, we’ll just get a cycle of small crises, like that in Japan and the UK, which don’t bring inflation back down and only provide temporary relief to stock markets.
Until central bankers lose control of a crisis badly enough to cause deflation, any stock rallies will only be bear market rallies.
This might seem controversial. But consider the history. Each peak in tight monetary policy has been punctuated by a financial crisis. And only such a crisis allowed for loose enough monetary policy to subsequently goose markets higher again. Because it gives the central bank a ‘get out of inflation free’ card. They could go back to absurdly loose policy once more. They’re allowed to prioritise bull markets only when inflation is in a box.
The fact that these crises have been getting bigger and more systemic over time is, of course, nothing to worry about. Financial crises that force central banks to overdo it, leading to proper inflation, are as rare as…pandemics, you might say.
Editor, The Daily Reckoning Australia Weekend