The primary mission of central banks has traditionally been to contain inflation. In the words of the Bank of Canada, “At the heart of the Bank’s monetary policy is a commitment to maintaining low and relatively stable inflation — in particular, to keep the rate of inflation close to the 2 percent midpoint of the 1 to 3 percent target range.” However, in the past decade, other motivations besides inflation moved to the center of their decision-making, such as employment and economic growth. The result is central banks around the world purchasing trillions of dollars of domestic sovereign debt.
The Inflation Central Banks Fight is No Longer Relevant
The traditional inflation targets apply to goods and services. I believe, however, that where central banks are still focused on inflation, they are fighting yesterday’s inflation. This is why, in the past ten years, they have failed miserably to stimulate the economy. Their monetary policy explanations can no longer clarify what happens. The world has changed and central banks did not keep up.
Inflation in the services industry is virtually nonexistent, and insensitive to monetary policy. Digitalization will provide lower costs of services, often to the detriment of employment. Services are increasingly provided by immaterial services on the cloud. About 62 percent of the U.S. economy is in services.
The inflation in goods continues to exist, but the share of manufacturing in those economies has fallen dramatically in already industrialized countries. Attempts to “bring back our factories” have proven ineffective. However, emerging markets have become the center of manufacturing due to their ability to produce at lower costs. China alone represents 28 percent of the world’s manufacturing, twice as much as the United States. This is also true for the technology we use in daily life, such as computers, smartphones, chips, and other electronic equipment.
The area of most concern is agriculture: hunger is increasing around the world, and food and beverage quality are serious questions — even in the United States, agriculture barely represents 5 percent of the economy. This has therefore little to no impact on the inflation rate.
Monetary policy produced neither the expected growth, nor employment.
Interest Rates are Increasingly Meaningless for Investments Only on Financial Assets
While the impact of short-term interest rates (the main monetary policy tool) on the increased indebtedness of corporations could have had a stimulating impact, central banks never really understood corporate investment decisions.
A CEO deciding on an investment because the central banks’ short-term rates have been reduced by 50 basis points (0.5 percent), should be fired immediately. Investments are long-term decisions based on expectations of return that are driven by a number of factors.
At today’s low-interest rates, the inflation impact is not on traditional inflation but on investment assets.
When the Federal Reserve launched a $3 trillion government bond purchase, it inundated the already liquid market with cash. As if it were not enough, it reduced short-term rates, brutally affecting fixed income investments and making them unattractive.
To get a yield, only the stock market was available. Their QE operation did not go to investments that built the economy, but instead financed the U.S. Treasury and implicitly (not intentionally but predictably) channeled public money toward the stock market.
By doing so, they also lowered the interest on deposits or bonds to zero. This affected retirees, pension funds, insurance companies, and other fixed-income investors, slicing savings income by 75 percent in Japan, Europe, and the United States.
This expropriation (or taxation) of savings had serious consequences on asset inflation while it had no inflationary effect on goods and services.
Creating a $20 Trillion Asset Bubble
The chart below says it all. The balance sheet of these six major central banks has increased from $6 to $25 trillion since the financial crisis. Their denial is contradicted by their own Bank for International Settlement that published an unambiguous paper stating that bank balance sheets matter.
In other words, central banks and governments have created a huge bubble of around $10 trillion that inflated assets, with no effect on investments, except perhaps, in real estate.
One does not need to go further to understand why the S&P 500 (at 43 times earnings) has tripled while earnings did not increase over the past ten years. The bubble of crypto assets can be explained by a lack of “attractive” opportunities but more importantly, constitutes a flight away from money. Tesla trading at 1,300 times while investing $1.5 billion in Bitcoin is a perfect demonstration of a complete dysfunction of the role of capital markets.
This myopia that extends to the new monetary theory of “the debt myth” is leading us to a catastrophic financial crisis that central banks will not be able to contain. The fire created by the assets in their balance sheets has blazed out of control — with nobody to put it out. Central banks have launched a QE strategy that has no possible exit.
It is time for central banks to do everything they can: increasing interest rates before it is too late will not affect the real economy. They must stop buying massive assets. Reinstating risk premiums is a critical policy that has been relinquished: we live in a schizophrenic world where the financial assets grow and the economy is at best, sluggish.
And it is urgent.