Central banks, Inflation and Debt: We’re in trouble…

Blain’s Morning Porridge, May the Fourth 2022 – Central banks, Inflation and Debt: We’re in trouble…

“Who’s more foolish: the fool or the fool who follows him?

This Morning – Central Banks have one real job: avoid inflation! It’s here, and the consequences will be devasting as conventional rate-hiking wisdom is used to fight a wholly exogenous supply side shock. There may be alternatives, but “credibility” is everything to Central Banks.

May the Fourth be with you! It’s Star Wars Day!

Which is kind of apt as the global economy feels like it’s about to do a Death Star impression: exploding in a fireball of incandescent fury… all because someone skimped on the design of a monetary policy exhaust vent… You know the rest…

Central Banks – Its all about Central Banks

It’s all about central banks this week. Today the Fed is set to raise rates by a “massive” 50 bp and announce plans to cut its balance sheet. Tomorrow the Bank of England might go full hog and also hike 50 bp (taking its benchmark rate to 1.25%, the highest since 2009) and announce its Quantitative Tightening Plans. (Forget the ECB for the time being…)

Lies ahead does pain and misery… said Yoda. It will get worse. If you think 1% UK rates will even scrape the sides of 8% plus inflation.. think again.

Central Banks have only one real job. (Forget all the gibberish about full employment or other such distractions.) They exist to protect economies from the ravages of Galloping Inflation.

Inflation is a dread economic disease that consumes empires, destroys nations, and turns sound economies to dust. Yet today, central bankers are hoping they can thread economies through the eye of a rising inflation storm, and inflate away the debt consequences of the last 14 years of monetary experimentation. (Simple bond market rule: inflation makes repaying long dated bonds simple.)

It’s going to be a rough ride. There are estimates energy, food and commodities supply instabilities will trigger double-digit inflation by Q3 – which could still accelerate sharply as supply distortions magnify. The likelihood is the global economy slips into recession.

Every 50 or so years, inflation returns. That seems to be an irrefutable rule of economic growth. As economies rise and fall in the boom and bust cycles we were once so familiar with, imbalances generate endogenous frictions sufficient to ignite inflation – price rises triggering wage demands, for instance.  Conventional wisdom says there is only one cure – stop the economy overheating by raising rates. It’s a blunt and imperfect tool, but inflation is not a laughing matter…. It needs to be addressed… robustly, say monetarist paladins.

While my city contemporaries are scaring their younger staff with tales of 14% interest rates and 19% mortgages, you can feel the whole economy shudder as folk contemplate the implications of higher rates on the value of their pensions and homes. The smarter ones are more worried about job security than at any time during the pandemic. I am terrified what it may mean for my family. I fear our economies lack the resilience we had back then.

Anyone with a modicum of understanding knows the crisis is coming. A monetary unravelling is about to occur that going to cost jobs, livelihoods and leave nations perhaps as economically damaged as Ukraine. It feels unavoidable. When it happens, the social consequences will be enormous – and I am seriously concerned about the ability of our “modern” economies like the UK to absorb the coming pressures.

Ken Rogoff, ex-IMF economist, is on the wires saying the Fed needs to hike up to 5% to avoid a perfect storm of recessions. (Anyone still using “perfect storm” should probably be shot for the crime of lazy metaphors.) Smarter minds than I say the risks have been allowed to build up by central banks who have been too timid to address inflation and implement appropriate policies – despite seeing this crisis approach.

That’s kind of unfair. Central Bankers are not bad people. They did what they could over the past 13 years – trying to stabilise the post Global Financial Crisis economy through a raft of unconventional monetary experimentation, policy choices the likes of which we’d never seen before. NIRP, ZIRP and QE (Negative Real Interest Rates, Zero Real Interest Rates and Quantitative Easing, since you were wondering) were all employed to stabilise the post GFC economy. Without them.. we’d have probably seen a wave of sovereign defaults, deep recession and increased banking failures causing industrial crisis. But there were consequences.

During the pandemic, Central Banks played their part with emergency rate cuts and a host of other emergency measures in conjunction with governments; from bounce back loans to furlough programmes. They saved the global economy from a Covid meltdown.

But monetary and fiscal interventions since 2008 have had massive consequences and created intense market distortions. They created the financial asset bubbles (that are now deflating) and have distorted the efficient allocation of capital by financial markets. By inflating the value of financial assets they made the rich richer, and the poor relatively poorer. The result has been widening income inequality.

We’ve always known that at some stage the distortions of monetary policy would need to be addressed and purged – but… is this really the time to try?

Conventional economists – the ones in positions of power in Central Banks and editing national newspapers – are prescribing a course of economic purgatives to address inflation though conventional higher rates. Such conventional policy will drive a wave of business failures, a bankruptcy quake, a redundancy shock, and financial retrenchment. It will be described by politicians as tough medicine, but we will be told it will mitigate inflation and unravel the systemic instabilities that have multiplied in the system as a result of post 2009 experimental monetary policy. It will be look profoundly unfair as the poorest in society will suffer most.

It will all be a bit: “To save the global economy, we had to destroy it..”

A few brave souls and economic free-thinkers have noted that current inflationary pressures have precious little to do with normal endogenous economic demand factors. The current tsunami of monetary inflation has everything to do with the current round of 3-Sigma exogenous supply shocks – soaring energy and food inflation triggered by the War in Ukraine, and supply chain breakdowns in the wake of Covid.

If the global economy could address previous exogenous shock like Covid with constructive monetary policy, why not this exogenous inflation shock? I read a great line from David Janny, a financial advisor at Morgan Stanley, whose stuff I try to read: “The Fed can’t print commodities but they can certainly could expedite a recession.”

Trying to treat an anaemic global economy on the verge of collapse though a course of bleeding, leeches and austerity fiscal programmes looks a recipe for social disaster. It hasn’t worked before. The consequences will be economic pain for millions of homeowners as mortgages soar, consumption plumets, unemployment trebles, while inflating away national debt. It’s a painful trade off.

So why are central banks going to do it? As I said above, they hope they can navigate this inflation storm, and use it to inflate away debt. It’s no secret national debt has ballooned since the GFC. UK Govt debt has risen from £1 trillion in 2010 to £2.3 trillion today.

Yet, the Bank of England currently holds £847 billion of Gilts – UK government debt. If they sell them into the market, that would create the expectation of a shocking and massive supply glut that will have one consequence – pushing up the yield on gilts to astronomical levels. It will mean the UK has to pay much, much more on any future gilt borrowing, severely curtailing the ability of the Government to fund its way through any further exogenous shocks – like war – through Gilt issuance.

So, let me once again propose a solution.

Every time the UK Treasury raises debt it does so by instructing the Debt Management Office to sell new Gilts. The DMO contacts the markets and sells them the new Gilts in the morning. Let’s say it’s a £10 bln issue. The £10 bln immediately appears on the balance sheet of the UK Treasury as a liability. In the afternoon, the same banks that bought the Gilts in the morning, sell them to The Bank of England (at a small mark-up, of course), where the new Gilts show up as an £10 bln asset on the Bank’s balance sheet.

Lightbulb moment: A liability on the Treasury balance sheet and an asset on the Bank’s balance sheet…. That is an accounting issue. It is easily solved. It does mean £10 bln new cash has been added to the economy. (That’s effectively exactly the same as what happens when you borrow £100 from a high street bank – it doesn’t have £100, it “magically” creates it…)

Since the current inflation shock is exogenous it doesn’t really matter that £10 bln has been added to the broad money in circulation. It would if the inflation shock was endogenous. Monetarist economists will be swearing at me at this point – they will not agree.

Why don’t the Treasury and the Bank simply write off the £847 bln of Gilts the Bank holds – via the simple expedient of the Treasury buying the Gilts back in return for a Zonk – a single penny sized coin bearing the Queen’s head and face value of £847 bln. It could be displayed in the Bank’s rather fine museum. It may have a notional value of £847 bln, but be worthless and priceless at the same time.

The UK’s national debt will then fall to a perfectly manageable level, allowing the country to combat this exogenous financial shock with supportive and appropriate policies.

But, of course it won’t happen. That’s because Central Banks care most about their credibility. No Central Bank would dare take such a radical step if it might cost credibility, on the basis that if a national central bank loses credibility, then the currency will collapse, triggering a further inflationary tidal wave and a loss of national prestige..

But.. I bet the Fed, the ECB and BOJ are all thinking about it..

Five things to read today:

BBerg – Bank of England Poised to Hike Interest Rates to 13-year High

BBerg – UK Pay for Finance Workers Surges at Double the National Rate

FT – Bond bull market “has come to an end”, Guggenheim’s Minerd says

WSJ – Stocks and Bonds are Falling in Lockstep at Pace Unseen in Decades

CNBC – Hiking rates is of “absolutely no use” against supply shock inflation, says investment advisory firm

Out of time, and back to the day job..

Bill Blain

Strategist – Shard Capital