Can You Trust the Fed and the ECB?
May 31 2017
Is structural inflation likely in the future? Is a more severe erosion of the value of our money than, let’s say, has been the case over the past 30 years likely? These are two important questions for anyone who asks himself/herself whether his/her capital should be protected against (high) inflation's voracious appetite.
Let us immediately start off with the easiest question, that is, the first question.
Ever since the moment the West changed its disciplining system of the gold standard for the fiat money system – a system in which central banks can print unlimited amounts of money and in which the value of our money merely depends on our trust in these monetary institutions, our experiences teach us that structural inflation is inherent to that new monetary system. Since the end of the Second World War, the Netherlands enjoyed, for instance, only one year without any inflation. In the decades and centuries before the Second World War, years with price deflation were just as normal as years with price inflation. For me, this fact was reason enough to describe in 2012 the period after the gold standard with the term “money murder.”
The second question is tougher to answer, because every answer would be subjective. In my book “Money Murder” published in 2012, I argued that higher than average inflation is not unavoidable in the future. When would this be the case? This would be the case when central banks tighten the monetary reins in time and with sufficient force.
But what does “in time” mean? And what does “with sufficient force” refer to? What are the odds that central banks will indeed react in this manner?
Ignoring the Law
Central banks are “in time” when they tighten monetary policy way before inflation gets out of hand. And they tighten with “sufficient force” when they do it at a pace similar to the pace at which they expanded monetary policy before the beginning of the crisis. If we then, with these definitions in the back of our mind, look at the most important central banks, such as the Fed, ECB or the Bank of England and their respective policies, what do we see? Are they “in time”? And do they act with “sufficient force”?
Let us begin with the Bank of England. The British central bank has an obligation by law to assure that inflation in the mid-long term (or, better said, during the next two years) remains at 2 percent. Lowering unemployment or targeting something similar is no part of the objectives of the BoE. If forecasts of the British central bank reveal that inflation in the mid-long term will end up below or above the 2 percent target, then the bank should either raise or lower interest rates to reach its objective.
At the time of writing, British inflation is at 2.7 percent. That is too high given the inflation target. Yet what is truly relevant for future monetary policy in the UK, is what the central bank expects inflation to do in the coming years. And the central bank stated that inflation will remain above 2 percent for the next three years. The interest rate committee of the bank, despite all this, decided with an overwhelming majority, 7 votes in favor and only one against, to leave the official rate unchanged at 0.25 percent.
Why? Because the bank blames the weaker pound for higher inflation and because the interest rate committee “must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity. (…) Attempting to offset fully (...) inflation would be achievable only at the cost of higher unemployment (...),” as we read in the latest Inflation Report of the bank.Strictly taken, the British central bank is breaking the law it should seek to comply with. As we said before, lawmakers have given the bank the task to keep inflation at 2 percent and not to strike a balance between that task and supporting the labor market or aiming for a certain unemployment rate.
On the other side of the ocean, we see something similar. The Fed has somewhat broader defined policy objectives than her British and European peers. The Fed is, after all, tasked with making sure inflation remains low (which means in practice a price inflation of about 2 percent a year as well) and reaching full employment. The latter boils down to maintaining the unemployment rate somewhere near 5.5 percent.
When the Fed lowered interest rates to zero percent and began purchasing US Treasuries on a massive scale, its so-called quantitative easing, inflation was below zero percent and the unemployment rate at about 10 percent. Today, as time passed, unemployment stands at 4.7 percent in the US and inflation at about 2 percent. In short, it is about time that the Fed quits purchasing government bonds and normalizes the official rate.
The former has already happened: the Fed does no longer purchase government bonds through its quantitative easing program. However … the interest payments and repayments of principal of the in the past purchased US Treasuries are still being used by the Fed to roll-over and purchase new government debt, so quantitative easing is in fact still ongoing, even though it is on a far smaller scale.
The second element, normalizing the official rate, remains a distant dream. The bank has hiked interest rates, but at an extremely slow pace, much slower than the rate at which the Fed lowered interest rates. And everything points at the fact that borrowing costs will only increase very gradually in the future.
To conclude, we will take a closer look at the ECB. The bank must assure that the inflation rate remains below, but near 2 percent annually. When the bank began purchasing government and corporate bonds on a massive scale within the Eurozone, inflation was a bit below 0 percent and the risk of a recession was high.Now, however, annual inflation in the Eurozone stands at 1.9 percent and economic growth has been higher than in the US since the beginning of 2015. Yet, the ECB persists in keeping the official rate at 0 percent. And the bank even states that that rate can be lowered even further in the near future. That inflation of 2 percent – which, by the way, even according to the ECB´s very own economists will remain below but near 2 percent in the next two years – has been belittled by the bank by saying that if we exclude food and energy prices, inflation is not nearly as high. As if the common man, who the ECB (let´s not forget) supposedly serves, would even care: price inflation is price inflation. Irrespective of its causes, the cost of living is going up.
Our First Line of Defense Has Been Wiped Out
In other words: the three most important central banks are, in my view, certainly not tightening their monetary policy “in time.” The ECB and the Bank of England have not even begun to tighten. Therefore, they are failing, per definition, to tighten the monetary reins sufficiently. And when they start to tighten monetary policy, the experiences with the Fed, ever since that bank ended her quantitative easing program, and the many statements by central bank board members in Frankfurt and London that this process will be very gradual, means that it is almost completely certain that the central bank will tighten at too weak a pace.
To be honest, it does not surprise me that the major central banks such as the Fed are neither in time nor tighten sufficiently in order to avoid an assault on the savings of millions of people who trust the banks.
In a speech at the beginning of January 2013, Ben Bernanke, the Chairman of the Fed at the time, answered a question from the audience by arguing that “the worst that the Fed can do, is to tighten too soon.” He said, thus, without explicitly stating it, that tightening too soon is the worst thing the bank can do. How do you as a central bank assure that you do not tighten too soon? Exactly, by being rather safe than sorry and tighten too late. That is what is happening right now.And so, we are back at square root with the question whether a higher inflation than, let´s say, what we have been used to in the past thirty years, is likely? Assuming that inflation is always and everywhere a monetary phenomenon, that is, the consequence of maintaining an expansionary monetary policy for too long (or: print too long too much unbacked money), I think the odds are high that inflation in the future will be higher for an extensive period than what we are used to. The decline in purchasing power will be more serious than in the past. Mainly because our first line of defense, that is, the savings rate, is failing us, especially in the Eurozone: now and the coming years as well (I should organize a meeting for interested readers regarding this subject someday soon, I reckon).