Central banks and interest rates: myths vs reality

Central banks and interest rates: myths vs reality

In June of last year, Jerome Powell, the Federal Reserve Chair, admitted, “We now understand better how little we understand about inflation.”

That alarming, but at least honest observation from the world’s most powerful central banker, comes despite the Fed employing more than 400 Ph.D. economists who enjoy access to the world’s most up to date data.

What is truly disconcerting though, is that governments around the world have happily passed on responsibility for managing inflation, and usually unemployment as well, to central banks via the control of monetary policy. But they essentially have only one tool to do that: interest rates.

Passing on that responsibility to central banks rests on some long-standing beliefs around monetary policy that sound fine in theory but lack real world evidence to back them up.

For example, the presumption that raising or lowering interest rates can control inflation. During the 2010’s, central banks around the world were concerned about deflation, that is, inflation being too low, so the biggest central banks in the world cut interest rates to never before seen levels.

The United States had effectively zero interest rates between 2010 and 2016, yet inflation averaged only 1.6 per cent per year over that period. Over those same seven years interest rates in the Euro Area averaged about half a per cent but inflation was -0.1 per cent, and in Japan rates were stuck at zero yet inflation averaged only 0.2 per cent.

Likewise, if high interest rates are supposed to cure inflation, how is it that Argentina can have an interest rate of 78 per cent yet inflation is 102 per cent? Defenders of orthodox monetary policy would say Argentina’s long been a basket case, but that’s the point, its interest rate has been above 40 per cent for the past five years but it has failed to control inflation.

Another shibboleth of monetary policy is the so-called Phillips Curve, which asserts that inflation and unemployment are inversely related. That’s why the Reserve Bank and the Fed regularly talk about the 50-year low unemployment levels and the inflationary risk from the price-wage spiral. The theory is that low unemployment causes such high demand for workers that they will flex their bargaining power and drive up wages, so raising inflation.

That may have been an issue 50-plus years ago when more than 60 per cent of the workforce belonged to a union, but with now only 9 per cent of Australia’s private sector in a union, things have changed. Wage increases have been below the CPI for the past nine consecutive quarters in Australia, see chart 1, and real average hourly earnings in the US declined by 1.3 per cent over the year to February, meaning it has been a deflationary influence in both countries.

 

Chart 1: Australian wages growth has lagged the CPI for the past 9 consecutive quarters

Chart 1: Australian wages growth has lagged 
the CPI for the past 9 consecutive quarters

 

In fact, Quay Global Investors analysed the US inflation and unemployment data between 1985-2020 and found there was no meaningful relationship – see chart 2. 

 

Chart 2: there has been no meaningful relationship between inflation and unemployment in the US over the past 40 years

Chart 2: there has been no meaningful relationship between 
inflation and unemployment in the US over the past 40 years

 

However, there have now been five different analyses covering the US, UK and Australia, that have each found corporate profiteering accounts for the majority of inflationary pressures in each country. That is reflected in US corporate profit margins hitting a 70-year high last year. One of those studies dubbed the phenomena “excuseflation”, because companies were using the first bout of inflation in years as cover to raise prices as much as they felt the market would bear.

Yet central banks continue to focus on consumers and households, with no mention of the role played by companies. By contrast, at the start of the pandemic the Japanese government made it clear to companies they would be watching for opportunistic price gouging, resulting in an inflation rate that peaked at about half the rest of the developed world, despite importing almost all their food and energy.

Also, monetary policy is frequently, and correctly, referred to as a blunt instrument because it can only work indirectly, by encouraging or discouraging people and businesses to borrow money and it can take ages to have any effect. The usual expression is that it operates “with long and variable lags.” However, all the central banks continue to say they will be “guided by the data”, but that data, be it the CPI, unemployment or industrial data, is all backward looking. There is an obvious logical mismatch.

Another logical mismatch is expecting that raising interest rates, which can only influence demand driven inflation, will do any good against supply driven inflation. For example, the floods last year contributed to double digit food inflation. Obviously, families have to eat, so raising interest rates is entirely non-sensical as a way to counter those inflationary effects.

The very clear problem is that by sticking dogmatically to those underlying economic theories, without accounting for the lack of real world evidence to back them up, central banks risk pushing economies into recession. Central bankers are muscling up trying to show they can be as tough as Paul Volcker, who was credited with stopping the inflationary episode of the 1970s-80s, but there are compelling arguments to suggest he gets way too much credit. They insist the pain of inflation, which by their own admission they don’t fully understand, is worse than the pain of people losing their jobs or their houses.

Interest rates can definitely play a role, after all, if central banks push interest rates high enough they will inevitably force a recession, which will certainly have deflationary consequences, but it’s ridiculous to argue that’s the only way to address the problem.

There are no easy solutions to controlling something as mysterious as inflation in a modern, complex economy, however, acknowledging the critical role fiscal policy plays would be a start. Professor Isabella Weber of the University of Massachusetts, who specialises in inflation, argues governments should explore strategic price controls, which have been extremely effective in the past, such as during war times.

However, until the dogmas of orthodox economic policy are left behind, smart investors need to remember to base their investment decisions on what they think will happen, not what should happen.

Don’t expect anyone to ring a bell at the bottom

Don’t expect anyone to ring a bell at the bottom

Investors have endured one of those years that tests patience and fortitude as share markets have ridden waves of despair and optimism. At its worst this year the Australian market was down more than 15 per cent from its highs, but the bellwether US markets have been rocked, with the S&P 500 down almost 26 per cent at its worst and the NASDAQ 33 per cent.

As is typical with bear markets, we’ve also seen some decent rallies, like June to August which saw an 11 per cent rise in the ASX200 and 18 per cent in the S&P 500.

Share markets are in the midst of another rally now, and the inevitable, and unanswerable, question on every investor’s mind: is this just another bear market rally or do we get on board?

It’s at times like this that smart investors might look to experts for authoritative insights on what to expect from financial markets. The reality is, however, none of those experts are completely reliable.

Central banks

The correction in financial markets this year was prompted by central banks, especially the US Federal Reserve, aggressively raising interest rates to tackle inflation. Yet on 29 June this year, the Governor of the US Fed, Jerome Powell, told a European Central Bank Forum,

“I think we now understand better how little we understand about inflation.”

That brutally honest, but nevertheless disarming confession, comes despite the Fed having hundreds of PhDs with access to the best information sources available.

Similarly, in 2012 the Fed started releasing where each governor expected interest rates and inflation to be over the coming three years, which came to be known as the ‘dot plots’. But it became clear the governors’ best guesses weren’t much better than anyone else’s, prompting Powell to say,

“The dots are not a great forecaster of future rate moves…just because it’s so highly uncertain. So, dots are to be taken with a big grain of salt.”

Likewise, you need only recall the now notorious reassurances from our own Reserve Bank as recently as November 2021 that interest rates would stay low until 2024, only to unleash the most aggressive rate rise cycle in decades six months later.

Economists

Economists’ opinions are often quoted not only for economic issues, like the outlook for inflation and unemployment, but financial markets as well. But in 2018 the IMF examined economists’ GDP forecasts for 63 countries over the 22 years to 2014 and found on average only 3 per cent forecast an impending recession eight months ahead of it actually starting, and only 9 per cent three months ahead.

Even Nobel Laureate, Ben Bernanke, the former Governor of the US Fed, said in May 2007 that subprime mortgage issues ‘wouldn’t seriously hurt the economy’. Only four months later the US share market began a 50 per cent dive, and those same loans led to the Global Financial Crisis.

Financial analysts and strategists

Most financial strategists will tell you that making forecasts about what markets will do over the next year is a mug’s game. There are simply too many variables, the most unpredictable of which is human sentiment, making the room for error enormous.

One study looked at the average S&P 500 forecast made by the 22 chief market strategists of the biggest banks and brokerage firms in the US from 2000 to 2014 and found the average miss was 14.6 per cent. That’s in absolute terms, meaning if the share market rose 10 per cent, the average forecast was for either 24.6 or -4.6 per cent.

Currently, many analysts argue share markets can’t have bottomed until corporate earnings have been downgraded enough to reflect the likelihood of a recession coming next year. So far US earnings forecasts for 2023 have been reduced by roughly 7 per cent, however, the S&P 500 was down by almost 26 per cent. It’s impossible to know if that difference wasn’t the market already factoring in lower earnings.

Experts may sound like they’re certain about where markets are headed, but in reality, they’re guessing like anybody else. If investors opt to wait for more ‘clarity’, by the time it comes, the markets will have already moved. The best option is to have a long-term plan and stick to it, because, as the truism goes, they don’t ring a bell at the bottom.

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