There’s an old adage that central banking is all about having the guts to “take away the punchbowl just when the party gets going”. Unfortunately for history, the man who said it also nicely demonstrated how hard it is to do.
Actually, it’s not very hard at all. You just have to raise interest rates. That’s it.
The challenge is putting up with the burning effigies with your face on them when you do.
Anyway, William McChesney Martin Jr was chairman of the Federal Reserve between 1951 and 1970. So, he had plenty of opportunity to prove his adage. But that’s not how things unfolded.
The year before he took the helm, US inflation sat at 1.26%. The year he took the chair, it soared to 7.88%! That’s almost as high as it is now…
But… that jump was due to the outbreak of the Korean War. And prices soon came right back down.
I wonder if there’s a lesson there for our times…?
Martin stuck around for long enough to get stuck with another war. By 1970 he was dealing with inflation above 5% and Vietnam.
Some argue that the story of US inflation is largely tied to wars.
Why? Because during a war, it’s especially hard to remove the government’s punchbowl. You get accused of a lot of nasty things if you pull away the government’s funding while it’s making the world safe from communism.
Despite Martin’s unimpressive performance in terms of inflation, his adage remains… an adage. And not much has changed.
These days, central banking is all about spiking the punchbowl sufficiently to keep the party going until someone passes out. And then to administer the cure, which happens to be hair of the dog.
But I want to go on a different drug analogy today. Alcohol just doesn’t come close to explaining what central bankers have been up to lately…
And so we’re talking marijuana instead of alcohol. And our question is how high central bankers will manage to get.
The answer is not high enough, and nowhere near high enough to impress prominent marijuana advocate Snoop Dogg.
He’s probably the only central banker out there who could get high enough. However, I had better explain why marijuana is my drug of choice…
The last 40 years of economic policy and financial market action can be understood as a sequence of bubbles and bailouts brought on by central banks. Specifically, they bring on the bubble, and then the bailout too after the inevitable bursting of the said bubble.
It’s always difficult deciding where to begin the explanation of a cycle, but here goes…
The story begins when central bankers are faced with some sort of crisis. They lower interest rates to help the economy and financial markets deal with it. This move gets the next boom going.
But that boom becomes a bubble when the central bankers forget to remove the punchbowl as Martin advised (but failed to do). The bubble eventually overflows into inflation, which makes central bankers tighten rates. This pops the bubble they inflated, triggering the next crisis.
And then central bankers jump back in to save the market with lower interest rates, funding the subsequent bubble, and rounding off the cycle.
That cycle has been repeating since the 1980s. But what is noticeable about it is that it requires a lower peak in interest rates each time to prick the bubble and trigger the crash. And it requires ever lower rates to get the next bubble going again each time.
Alfonso Peccatiello did a better job of explaining this than I can on Twitter:
Peak in Fed Funds before the “something breaks” moment:
2000: 6.50% (Dot-Com)
2008: 5.25% (Real Estate)
2018: 2.50% (Credit/Risk Sentiment)
2023: 4.00% priced in
And indeed quite a few things are breaking already.
So, when bonds?
Source: Alf @MacroAlf
Alfonso only mentioned the last few bubbles which popped, and the peak in interest rates that popped them going back to 2000. The same story applies right back to 1980, but nobody remembers the Asian Financial Crisis (1997-8) or the Savings and Loan Crisis (late 1980s).
But the crucial point is that it takes ever lower interest rate increases to pop the bubble. The reason why is simple. The more debt, the less rate hikes it takes to dish out the equivalent amount of pain. As borrowers are finding out right now…
Another metric to consider is the low starting base. This was wonderfully explained by the most high-profile victim of the current rate hiking cycle, Cathie Wood, who invests other people’s money in tech companies:
Volcker doubled the Fed funds from 10% to 20% in less than a year. Powell’s Fed has increased the funds rate 7-fold in the last year and is pointing to another double from here. Its moves already are more draconian than Volcker’s.
As I recently pointed out to the real estate agents trying to sell me a house, central banks have raised interest rates by an order of magnitude. Of course, this is only true because the starting base was so ridiculously low.
From 0.1% to 1% is a ten-fold increase, for example. Which only sounds exciting because 0.1% is so low.
And yet, there is some truth to the story too. People who borrowed at ridiculously low rates do feel that surge as rates rise in multiples. That is especially true for interest-only borrowers. Like companies and governments that never repay their debt, they just keep borrowing more to repay old debt as it comes due.
Anyway, more debt and a low base means that the pain of monetary policy is felt more acutely. Therefore, it doesn’t take as much of a rate hike to pop the bubble.
Now, and this is what Alfonso was getting at, the financial markets are pricing in interest rate hikes to 4% in the US. This would break the cycle of ever lower interest rates popping the bubble in dramatic fashion. It’d be far higher than what popped bubbles in 2018, triggering the worst stock market plunge to that date since the 2008 meltdown.
Alfonso’s real point is that he doesn’t expect interest rates to ever make it anywhere near 4%. He expects something to pop well before then. If it hasn’t done so already.
If something does implode somewhere in the financial system, (or already has done so, and there is no shortage of contenders for what might implode), then central bankers are likely to panic and return to their old playbook. That playbook involves cutting interest rates and quantitative easing (QE – the creation of money out of thin air to buy bonds). The playbook does not involve what has been happening in the recent past – the increasing of rates and quantitative tightening (the opposite of QE).
This would be good for bonds as an investment. Their prices rise as interest rates fall and central banks start buying them up again.
I agree with Alfonso’s analysis. And I think it’s so likely to play out that way that I’m already wondering what happens to inflation in that scenario.
Usually, in a financial crisis, inflation plunges into deflation, which is why central bankers act big to save us all. At least, that’s what they say.
I suspect they are really interested in saving their future and former employers on Wall Street and in the City – that was the originally intended purpose of central banks, after all.
But this is my really important take-away for you from today’s Fortune & Freedom: The motivations for why central bankers take action during a crisis might suddenly matter a lot. That is because they may be forced to choose between saving the financial system and continuing to hike rates because of inflation.
You see, this time, inflation might not come down much when the bubble pops. That is because inflation is being driven, to a great extent, by shortages and disruptions of various sorts.
The irony of this possible future situation is that, if central bankers do decide to take their official job seriously and prioritise inflation over saving their buddies in the local financial district, then they might be hiking rates to no avail. That is why Snoop Dogg could be as effective as Bank of England governor as anyone else.
You can’t fix a supply crisis with tighter monetary policy after all. But you can make it worse…