Time wasted watching central banks…
“Is there anyone here called John?” (Clinton Baptiste – Psychic from Phoenix Nights)
The financial services industry devotes an inordinate amount of time to discussing the outlook for central bank policy. This is perhaps not too surprising. Central banks have profound, albeit routinely exaggerated, influence over interest rates. Perhaps because of this influence, and the privileged view of the economic outlook these monetary rock stars are assumed to enjoy, their words carry a heavy weight in markets. There is now an industry within an industry minutely dissecting their every utterance, desperately trying to glean an edge over the competition on various aspects of the investment opportunity. The problems are severalfold.
First, central bankers are aware of the investor scrutiny and even welcome it as a means of exerting extra influence over the path of interest rates – their communications are painstakingly shaped accordingly. However, investors are in turn well aware of the attempts to influence them. This creates an ultimately deleterious hall of mirrors effect, characterised by much noise and very little actual signal.
Second, central bankers are mostly as blind to the vagaries of the future as the rest of us. Of course they are. There is no viewing platform, from which they can glimpse more of the future than the rest of us, exclusively reserved for them. This is not to suggest that central banks are not populated with hard working, very clever and well-intentioned individuals. They mostly are. However, many central banks are slaves to a left hemisphere world view in which maths and models, and a lack of common sense provide key struts to their overconfidence.
Investors and normal human beings can save themselves a lot of time. Trends in interest rates are mostly driven by factors well beyond the reach of the central banks. In fact, over longer periods of time, even prevailing economic theory does a poor job of explaining the tendencies of real and nominal interest rates.
Forecasting inflation…
It follows that inflation remains a poorly understood and statistically elusive phenomenon. We are now in a period where it is perceived to be too high, but we are only just out of a long period where it seemed too low. Academia has only recently debated the idea of targeting persistently higher inflation. The point being that inflation is not a subject where an easy consensus exists, even after many decades of research. There are many competing explanations for its comings and goings, with many economists clustering to grouped explanations with often religious devotion.
We need to be clear to start with. Price shocks, in either direction, are mostly unavoidable. The bit that central bankers and policymakers are so focused on are the so called ‘second round effects.’ This is when a price shock is effectively allowed to run its course unhindered. In the worst case, this can durably alter the prevailing psychology of your economy – wages and economy wide prices are capable of chasing each other higher in ever more deleterious circles. We have been here before. The great inflation of the 1970s is often held up as the example of what happens when these second-round effects are allowed to run riot. Businesses and their employees are ultimately distracted from the needs of maximal production by the need to simply keep up with prices. Stagnation, declining living standards and worse results. It took the famous central banker, Paul Volcker, to shock the system back onto right path with the painful rate hikes of the late 1970s and early 1980s.
Second, inflation is capable of invisibly transferring wealth from savers to creditors and vice versa. Your hard-earned savings are eroded when inflation is elevated, while large amounts of debt are deflated with the rate of inflation. For society, the government is mandated or tasked with wealth re-distribution, not central banks (although admittedly setting interest rates will have many in/direct impacts on business as well as society). However, as above, we are already dramatically overstating the precision central banking is capable of. Raising and lowering interest rates is blunt in the extreme. But the idea that there are subtler, more surgical, tools to deploy is fanciful as of yet.
The conundrum can be understood by referring back to my favourite bad analogy for the economy: a car. Like all cars, the various economies around the world have an optimal speed of travel – a pace of growth where all of our various resources are being used but not overused. Just like a car, if the economy travels too fast relative to its potential speed, there is trouble. Where smoke streams out of the bonnet in the car, soaring prices are generally the equivalent for the economy. Central bankers are basically tasked with helping the economy to travel at its sustainable, optimal pace. However, they are drivers with a steering wheel or an accelerator, but not both. They have too few instruments to essentially deliver on their mandate.
It gets worse. Unlike a car, we don’t get to know what the optimal speed of travel is for the economy – it is unobservable. Not only can we not see under the bonnet to any meaningful degree, but worse, the engine is always changing while we are moving. This means that the optimal speed of travel is always changing and therefore the rate of growth the economy can sustain without generating problematic inflation. If you want to further complicate the already fiendishly complex picture, you can add the fact that their various charges are still recovering from a once in a generation pandemic whilst also entering the next industrial revolution!
There are plausible arguments as to why the potential growth rate of the various economies around the world could have been shifted up or down by the strictures of the crisis, as well as the various policymaker responses. We are different to our 2019 selves. Our attitudes to saving, working, investing, and more besides may have been meaningfully altered. The fact that this latest pandemic and what has followed has applied such a common blow to humanity, we might expect the effects on our wants and needs, and therefore potential growth, to be considerable. That is to say nothing of how the advances in AI, quantum computing and various other areas of the technological frontier will change the trend in growth.
Reminding yourself that central bankers are as blind to the future as the rest of us can save you a lot of time to spend how you wish.
1. https://www.bankofengland.co.uk/working-paper/2020/eight-centuries-of-global-real-interest-rates-r-g-and-the-suprasecular-decline-1311-2018
2. Chambers, D; Dimson, E; Ilmanen, A; Rintamaki, P; (October 2024) – Long run asset returns – Annual review of financial economics, Vol 16
3. https://www.piie.com/blogs/realtime-economic-issues-watch/case-raising-inflation-target-stronger-you-think
4. Some more than others of course.
5. If real interest rates are kept positive, this effect can be muted
Contact us
0203 418 0257
info@onekc.co.uk
References
Source: https://www.brooksmacdonald.com/insights/central-banks-and-inflation
Central banks and inflation
Central banks and inflation
Time wasted watching central banks…
“Is there anyone here called John?” (Clinton Baptiste – Psychic from Phoenix Nights)
The financial services industry devotes an inordinate amount of time to discussing the outlook for central bank policy. This is perhaps not too surprising. Central banks have profound, albeit routinely exaggerated, influence over interest rates. Perhaps because of this influence, and the privileged view of the economic outlook these monetary rock stars are assumed to enjoy, their words carry a heavy weight in markets. There is now an industry within an industry minutely dissecting their every utterance, desperately trying to glean an edge over the competition on various aspects of the investment opportunity. The problems are severalfold.
First, central bankers are aware of the investor scrutiny and even welcome it as a means of exerting extra influence over the path of interest rates – their communications are painstakingly shaped accordingly. However, investors are in turn well aware of the attempts to influence them. This creates an ultimately deleterious hall of mirrors effect, characterised by much noise and very little actual signal.
Second, central bankers are mostly as blind to the vagaries of the future as the rest of us. Of course they are. There is no viewing platform, from which they can glimpse more of the future than the rest of us, exclusively reserved for them. This is not to suggest that central banks are not populated with hard working, very clever and well-intentioned individuals. They mostly are. However, many central banks are slaves to a left hemisphere world view in which maths and models, and a lack of common sense provide key struts to their overconfidence.
Investors and normal human beings can save themselves a lot of time. Trends in interest rates are mostly driven by factors well beyond the reach of the central banks. In fact, over longer periods of time, even prevailing economic theory does a poor job of explaining the tendencies of real and nominal interest rates.
Forecasting inflation…
It follows that inflation remains a poorly understood and statistically elusive phenomenon. We are now in a period where it is perceived to be too high, but we are only just out of a long period where it seemed too low. Academia has only recently debated the idea of targeting persistently higher inflation. The point being that inflation is not a subject where an easy consensus exists, even after many decades of research. There are many competing explanations for its comings and goings, with many economists clustering to grouped explanations with often religious devotion.
We need to be clear to start with. Price shocks, in either direction, are mostly unavoidable. The bit that central bankers and policymakers are so focused on are the so called ‘second round effects.’ This is when a price shock is effectively allowed to run its course unhindered. In the worst case, this can durably alter the prevailing psychology of your economy – wages and economy wide prices are capable of chasing each other higher in ever more deleterious circles. We have been here before. The great inflation of the 1970s is often held up as the example of what happens when these second-round effects are allowed to run riot. Businesses and their employees are ultimately distracted from the needs of maximal production by the need to simply keep up with prices. Stagnation, declining living standards and worse results. It took the famous central banker, Paul Volcker, to shock the system back onto right path with the painful rate hikes of the late 1970s and early 1980s.
Second, inflation is capable of invisibly transferring wealth from savers to creditors and vice versa. Your hard-earned savings are eroded when inflation is elevated, while large amounts of debt are deflated with the rate of inflation. For society, the government is mandated or tasked with wealth re-distribution, not central banks (although admittedly setting interest rates will have many in/direct impacts on business as well as society). However, as above, we are already dramatically overstating the precision central banking is capable of. Raising and lowering interest rates is blunt in the extreme. But the idea that there are subtler, more surgical, tools to deploy is fanciful as of yet.
The conundrum can be understood by referring back to my favourite bad analogy for the economy: a car. Like all cars, the various economies around the world have an optimal speed of travel – a pace of growth where all of our various resources are being used but not overused. Just like a car, if the economy travels too fast relative to its potential speed, there is trouble. Where smoke streams out of the bonnet in the car, soaring prices are generally the equivalent for the economy. Central bankers are basically tasked with helping the economy to travel at its sustainable, optimal pace. However, they are drivers with a steering wheel or an accelerator, but not both. They have too few instruments to essentially deliver on their mandate.
It gets worse. Unlike a car, we don’t get to know what the optimal speed of travel is for the economy – it is unobservable. Not only can we not see under the bonnet to any meaningful degree, but worse, the engine is always changing while we are moving. This means that the optimal speed of travel is always changing and therefore the rate of growth the economy can sustain without generating problematic inflation. If you want to further complicate the already fiendishly complex picture, you can add the fact that their various charges are still recovering from a once in a generation pandemic whilst also entering the next industrial revolution!
There are plausible arguments as to why the potential growth rate of the various economies around the world could have been shifted up or down by the strictures of the crisis, as well as the various policymaker responses. We are different to our 2019 selves. Our attitudes to saving, working, investing, and more besides may have been meaningfully altered. The fact that this latest pandemic and what has followed has applied such a common blow to humanity, we might expect the effects on our wants and needs, and therefore potential growth, to be considerable. That is to say nothing of how the advances in AI, quantum computing and various other areas of the technological frontier will change the trend in growth.
Reminding yourself that central bankers are as blind to the future as the rest of us can save you a lot of time to spend how you wish.
1. https://www.bankofengland.co.uk/working-paper/2020/eight-centuries-of-global-real-interest-rates-r-g-and-the-suprasecular-decline-1311-2018
2. Chambers, D; Dimson, E; Ilmanen, A; Rintamaki, P; (October 2024) – Long run asset returns – Annual review of financial economics, Vol 16
3. https://www.piie.com/blogs/realtime-economic-issues-watch/case-raising-inflation-target-stronger-you-think
4. Some more than others of course.
5. If real interest rates are kept positive, this effect can be muted
Contact us
0203 418 0257
info@onekc.co.uk
References
Source: https://www.brooksmacdonald.com/insights/central-banks-and-inflation
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