Is This the End of Monetary Policy Itself?

The economy doesn’t matter anymore. Neither do earnings nor risk. Nope, investing is just about guessing what central bankers might do next. After all, if we didn’t have them rescuing us every fortnight, can you imagine where financial markets would be?

Well, you might not have to imagine very hard because monetary policy has been falling apart lately…

I’m not just talking about inflation. The emergence of that forgotten enemy has cornered central banks this year. They can no longer do ‘whatever it takes’ to save financial markets because they’re supposed to be bringing inflation down at the same time.

But that’s yesterday’s news. The bit that’s responsible for the record-breaking rout in US stocks and global bonds.

Consider what happens next. I’m worried central banks are completely losing control in additional ways. And monetary policy might be the next casualty, hunted down by something called the Unholy Trinity.

But first, consider government bond markets, through which central banks conduct their monetary policy.

Quantitative Easing is really just buying government bonds. And interest rate moves are largely about pushing around the yields on government bonds.

The thing is government bond markets are in turmoil. And this undermines the ability of central banks to conduct monetary policy at all. Especially because, without a functioning government bond market, central bankers have bigger problems than inflation to worry about.

In Japan, for example, which has one of the largest government bond markets in the world (given how much debt the government is in), liquidity is very low. And when I say low, I mean non-existent.

Bloomberg highlighted the extraordinary state of affairs:

In a fresh sign of Japan’s dysfunctional bond market, the 10-year benchmark failed to trade for a third consecutive session Tuesday, the longest such streak since 1999.

The Bank of Japan’s overwhelming presence in the JGB market where it’s the biggest buyer under its curve control policy has exacerbated liquidity issues and led to a deterioration in market functioning.

This means nobody bought or sold 10-year Japanese government bonds for three days. It should be one of the most liquid markets in the world…

The problem isn’t new in Japan, which pioneered several of our monetary policy hacks. But it reveals how fragile markets are right now.

What could go wrong?

Well, in the UK, panicked pension funds recently tried to sell their UK government bonds to meet margin calls on derivatives trades gone wrong. But they couldn’t, according to the Bank of England:

Some funds had already tried to sell gilts and failed to do so.

The UK’s key reserve asset was unsellable.

This should be utterly terrifying given our financial system and risk management systems, as well as bank capital and liquidity requirements, are built on the assumption that government bonds are risk-free and liquid. This year, they’ve been neither.

First, the prices of bonds plunged. And now you can’t even sell them at all…

This negates the incentive to hold government bonds as a risk buffer. And undermines the justification for regulatory requirements that force institutions, like banks, to hold government bonds to protect them from a crisis.

Perhaps, more importantly, the government bond market in each nation has an important impact on local financial conditions. It’s a bit like the floor that all other debt is priced on.

If central banks don’t have control over a stable bond market, all other borrowing is in trouble too.

Not to mention the fact that governments would be unable to finance themselves without a functioning bond market…

That’s why the Bank of England had to abandon its planned quantitative tightening to rescue the pension system. Not for the sake of the pension system, but for the survival of the UK Government and the entire financial and economic system.

Chaos in bonds also makes it impossible to conduct monetary policy properly. What central bankers call the transmission mechanism — what carries central bank decisions into the economy — is broken.

This is why the governor of the Bank of England recently gave pension funds three days to sort out its mess — he needs to get back to tightening monetary policy to slay inflation. But he can’t when the bond market is on the precipice, which is why he had to reverse his ‘three days’ comment shortly after making it…

All this is bad enough, but I’m not finished. There’s another problem inherent in monetary policy: The fact that modern monetary policy is nothing more than a sleight of hand.

As the theory goes, when inflation is high, central banks raise interest rates. This slows down the economy and brings the cost of living down again. Easy, right?

Well, as borrowers can tell you, that’s not quite how it works. You see, just because mortgage repayments aren’t included in the consumer price index (CPI) doesn’t mean they aren’t real.

I don’t know about you, but I don’t care much whether my food shop or mortgage bill goes up by $150 — it’s still $150 more, either way.

But one shows up in inflation and the other doesn’t.

In other words, when central bankers raise interest rates, they raise the cost of living in order to fight the cost-of-living crisis. This makes no sense. Unless you presume away interest payments out of the definition of ‘cost of living’. And then remark: ‘Look, prices are falling’, but only because ‘prices’ don’t include mortgage costs…

So, yes, some prices may be falling if inflation comes down. But central bankers have merely shifted the rising cost of living from food and energy bills to mortgage bills instead. They don’t actually solve diddly squat, let alone reduce the cost-of-living crisis. They’ve only moved it from inside the arbitrarily defined CPI to outside the CPI…

One important distinction is that interest rate hikes raise the cost of living for borrowers but not for the rest of society. Which is an interestingly divisive idea, right? ‘Let’s bring inflation down by undermining the spending power of a subset of the economy — those who went into debt. After all, they’re the ones who can bear it risk-free, right…? It’s not like they’ll cause a global systemic mortgage crisis or anything’…

When you look at it this way, monetary policy is a scam. It simply designated mortgage payments as not included in the definition of inflation and then set about managing the cost of living by shuffling it between the segments included in the inflation definition and the ones not.

Borrowers are the sacrificial lamb of statistical manipulation. Their overall cost of living is simply designated as less important. Their cost of living is a policy tool but is not reflected in the inflation statistics.

At some point, this scam will be objected to. Borrowers will not accept being the ones who get shafted in order to bring down the nation’s inflation statistics (but not the actual cost of living).

Especially when their own cost of living, which is surging thanks to higher mortgage bills, is conveniently excluded in the inflation statistics, and so the central bank doesn’t care about it.

All these problems with monetary policy have activated an ancient ill. Well, ancient in the context of the history of modern economics: I’m talking about the Unholy Trinity.

According to this theory, which was turned into an iron law by painful experiences around the world, governments and central banks must make a choice. They can only choose two of the following three things: Pegged exchange rates, independent monetary policy, and free capital flows.

Never mind why. Economic history is littered with politicians and central bankers learning this lesson the hard way. And yet, we seem intent on doing so again today.

You see, central banks are trying to bolster their currencies. From the Financial Times:

Across the world, the dollar’s surge is hurting economies, roiling financial markets, and leaving destruction in its wake. Some central banks now are pushing back.

On Friday, the People’s Bank of China became the latest central bank to intervene, trying to slow down the pace of renminbi depreciation against the dollar. The Japanese finance ministry started intervening a week before that. The Reserve Bank of India has tried to slow the rupee’s depreciation, and the Bank of England has been forced to hint of monster rate hikes to come after sterling fell to multi-decade lows.

According to a Bloomberg article, you can add the Central Bank of Chile to the mix of those trying to buoy their currencies.

The trouble is this brings the Unholy Trinity into play. Governments and central banks are trying to fiddle with exchange rates to prevent their currencies from plummeting any further, while they’re trying to conduct monetary policy to bring down inflation, and they’ve got free capital flows, meaning money can move across borders.

But something has to give. You can’t do all three. Not for long before a financial crisis breaks out. That’s the lesson of history and economic law.

The question is, what gives? Will we see capital controls with limits on international money movements? Will central banks be forced to let their currencies crash? Or will monetary policy prioritise the exchange rate over the inflation target, allowing inflation to go ballistic?

Japan has chosen the latter. The rest of the world is still in purgatory, being hunted by the Unholy Trinity.

Whether it’s chaos in the bond market, the underlying sleight of hand inherent in monetary policy, or the coming chaos that the Unholy Trinity causes, monetary policy is in trouble. And that means markets are too.


Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

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