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A Tale of Two Inflations

Mike Hollings, CIO, Shard Capital, writes an impassioned piece on, what he calls, the myopic attention to consumer price inflation from central banks over the last 40 years. Hollings argues the absence of Asset Price Inflation in the targets at the US federal reserve has led to economic inequality and social malaise we face today.


With apologies to Charles Dickens

It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way – in short, the period was so far like the present period, that some of its nosiest authorities insisted on it being received, for good or evil, in the superlative degree of comparison only

A Tale of Two Cities

The opening lines from a Tale of Two Cities are often quoted in the context of the duality that exists in life and the lessons we can and should learn from this reality. However, in practical terms, very few of us have any influence on the “reality” that is foisted upon us. We are frequently obliged to live with the consequences of the decisions and actions taken by others, sometimes to our benefit but equally many times to our disadvantage.

If those decisions, whose long-term consequences impact our lives negatively, are made by elected officials then we can at least take a modicum of comfort in the belief that a democratic process was at play and, in this context, we can reluctantly accept the outcome.

But if actions and decisions that negatively impact our lives are made by un-elected officials, particularly when those outcomes affect us so directly and have such very serious long-term consequences, not just on us but also on our children, it is much harder, if not impossible, to be sanguine in the face of such a situation.

Dire Straits

Let’s start with one, we would argue, undeniable truth…interest rates at pretty much zero across most of the developed world are NOT a sign of healthy economies or successful monetary policies. On the contrary, they are a clear sign that global economies are in such desperate straits that they require emergency level rates of interest just to survive. By now it is self-evident that central banks have so spectacularly mismanaged their respective economies that they cannot even hint at ending these extreme policies, let alone actually do anything about it.

This begs the obvious question…how on earth did we ever get into this situation?

From our perspective the problem starts with central banks…in fairness there are other “bad actors” in this sorry tale, but central banks must bear a large part of the blame.

Pointing the finger

We can go into the overconfidence demonstrated by central bankers over the last 30 years, or the intellectual dishonesty behind much of their thinking, or their reliance on outdated models to cope with new economic realities, but the truth is that they failed for one key reason, and in order to understand that reason we need to understand their remit, or at least their remit as they understood and interpreted it.

The road to hell

Let us focus on the most important and influential central bank in the world, the “primus inter pares” of the monetary “elite”, namely the US Federal Reserve Bank. We can skip the history and go to the purpose behind its creation in 1913, namely “to provide a more elastic currency, to provide the means of rediscounting commercial paper, to establish a more effective supervision of banking in the US and for other purposes”. All praiseworthy objectives, but then again, the road to hell is paved with good intentions.

In 1977 Congress amended the Federal Reserve Act and effectively gave the Fed a dual mandate:

  1. price stability (which they defined as Consumer Price Inflation (CPI) at or around 2%)
  2. maximum employment (which they now define as NAIRU* estimated to be around 4%)

As everyone knows there are two types of inflation:

  1. Consumer Price Inflation (aka CPI) which measures the rise (or fall) in the prices of a basket of consumer goods and services such as: rental equivalent, clothes, electricals, transport, recreation, medical care, etc. (In 2000 the Fed changed the measure to PCE which effectively attempts to do the same thing but just measures it differently).
  2. Asset Price Inflation which measures just about everything else such as: property, shares, bonds, life insurance, gold, land, fine wine etc.

Now, as we noticed, the Fed mandate only includes the first of these and not the second, which might strike right minded people as strange given that rapidly rising (or falling) Asset Prices are potentially just as economically destabilising as rapidly rising (or falling) Consumer Prices.

They say central banks always fight last year’s wars and so a myopic focus on consumer price inflation can be explained in the context of the very high CPI seen in the 70s and 80s, but what the Fed, and other central banks, seemed to have missed, (or if they didn’t miss it they certainly seem to have ignored it), was the extraordinary paradigm shift that the twin disinflationary forces which took hold of the global economy during the early 90s, namely globalisation and technology, would have on the global economy and therefore should have resulted in them reviewing and adapting part of their dual mandate, namely the definition of Price Stability in terms of a CPI/PCE target only.

Sitting here now it seems scarcely credible that they would continue with this single-minded focus on CPI targeting when the two structural disinflationary forces referred to above were effectively “doing their job for them”. There was no need to focus on “keeping inflation at 2%” because consumer price inflation (as they remembered it from the 70s and 80s) was no longer “a thing”…it was no longer a threat. Their thinking needed to adapt to the unprecedented change in global economic and social conditions…but almost inevitably it didn’t.

So what happened? Well, guided by this almost quasi-religious mantra of “2% CPI” they proceeded to lower rates to ensure their “inflation target was met”. But, and here is the supreme irony, rather than lower rates spurring Consumer Price inflation (which as we noted was under control from the twin disinflationary forces mentioned above) they instead spurred Asset Price inflation. To which central bankers reacted like police at the scene of a crime where they tell onlookers to “move along please, nothing to see here”.

And this is where terminology and narrative conspire to lead our un-elected officials down a path that is ultimately doomed to failure. Thinking of CPI/PCE broadly as “bad inflation” whilst thinking of asset price inflation as “good inflation”, or at least the type of inflation that can be safely ignored is, at best, unwise and more bluntly is downright foolhardy.

A question of bubbles 

You don’t have to be a genius, or indeed possess a Phd in Economics, to work out and understand that interest rates kept too low for too long encourages all kinds of speculation and ultimately lead to systemically dangerous asset bubbles.

In a paper written in 2000 Stephen G Cecchetti, (who had previously been head of Research at the Federal Reserve Bank of New York, but at the time was Professor of Economics at Ohio State University), very reasonably pointed out that “reacting to asset prices in the normal course of policymaking will reduce the likelihood of asset price bubble forming”. I’m not sure many of us would or could argue with that conclusion, but apparently Central Bankers can and do.

At this stage it is worth noting that legislators and regulators also bear part of the blame for the excesses that have been allowed to build in asset prices over the last 25 years, (repeal of Glass Steagall, “light touch” regulation, etc.) and also for the much weaker financial system in which we all operate these days.

The upshot is that by trying to fight these disinflationary forces by continually targeting CPI all they succeeded in doing was to blow a succession of bubbles, each of which was larger than the previous one and which was/is more systemically dangerous than the previous one, all of which had/have to be rescued by increasingly extreme monetary policies, begetting more asset price bubbles etc…

At some stage the grotesque excesses that exist within most financial markets will have to be addressed. We think that the most likely route to re-setting valuations will be through inflation, but not just yet. That said if/when CPI rears its ugly head again it will be the poor and those on fixed incomes who suffer the most as they are less able to protect themselves against the ravages of inflation than the wealthier members of society.

Ignoring, for now, that central banks messianic focus on Consumer Price inflation (to the exclusion of Asset Price inflation) has effectively bankrupted the next generation, the last 20 years have been great for those with assets…not so much for those without…so it is no surprise that wealth inequality is now at such extreme levels and that social unrest is on the rise.

Future prospective returns have been decimated by short-sighted central bank policies stretching back to the mid 90s. Without putting it too delicately, we have effectively robbed our children to enrich ourselves.

At the War Cemetery in Kohima there is an epitaph credited to John Maxwell Edmonds which reads:

When you go home, tell them of us and say, for your tomorrow, we gave our today.

Given the economic legacy bequeathed by central banks our generation’s epitaph should perhaps read:

When you grow up, tell them of us and say, for our today, we gave your tomorrow.

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