It’s time to reassess the ‘dark arts’ of central banks
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The US Federal Reserve this month signalled that it could start cutting interest rates in 2024. While the Board of Governors held rates steady, the majority now foresee a rate cut next year.
Markets were very surprised by the move, with the two-year Treasury yield falling sharply from nearly 4.7pc to around 4.4pc within just two hours of the announcement.
The markets were right to be surprised. In the weeks running up to the meeting, Fed chairman Jerome Powell had consistently communicated that the central bank would hold rates “higher or longer” to ensure that the inflation vampire would not rise once more from its coffin.
Between the time of its last meeting at the start of November and this meeting in mid-December, the data had not changed noticeably. Inflation is falling but there remain signs that it might be stickier than central bank policymakers would like, with US core services inflation remaining elevated. This has led many to suspect that the surprise announcement by the Federal Reserve might be political.
The weekend before the Federal Reserve Open Market Committee (FOMC) met, The Wall Street Journal published an article showing that Donald Trump had overtaken President Joe Biden in the polls, and that a key reason Trump had pulled ahead was because of Biden’s handling of the economy.
This is the latest episode calling into question the independence of central banks around the world.
If inflation takes off again – possibly driven by rising tensions in the Middle East – the Federal Reserve will have egg on its face, having missed two bouts of rising prices.
And there will be no shortage of Republican critics ready to accuse the central bank of playing politics.
Yet questions about the competency of central banks run far deeper. The latest round of rate hikes we have seen from central banks around the world are the culmination of 15 years of the largest monetary experiments since at least the Second World War. The fact of the matter is that we have never really had a public discussion of the merits and demerits of central bank quantitative easing (QE) programmes.
This is very strange because many central banks only received formal independence recently. The Bank of England, for example, was unshackled in 1997. The rationale for this was that monetary policy was now largely a settled scientific question. Economists, we were told, after decades of honing their theories had finally arrived at a scientific means of managing the economy.
If this were true, then no doubt central banks should be given the freedom of movement they need to manage the economy. After all, no rational person would say that an engineer should be told by government bureaucrats with liberal arts degrees how to build a bridge. If economics has solved the problem of macroeconomic management, then why have these same bureaucrats questioning PhD-endowed economists?
After less than 15 years of being granted independence, faced with the financial crisis of 2008 and its aftermath, the Bank of England decided that it was prudent to create an almost infinite supply of money and to flood the banking system with it. To a layman this might appear a strange thing to do.
It might even start to raise unsettling questions about how our financial system actually works and what our money is based on.
The economics PhDs told us, however, that it was absolutely necessary. If they did not flood the banking system with great gobs of money, our economies would sink into a depression the likes of which we saw in the 1930s. The initial rationale for this was that without the QE programme we would have seen mass bank failures. But as the mission so often does, the mission soon started to creep.
Perhaps there was a solid case that large liquidity provision needed to be provided to the banking system in the wake of the 2008 financial crisis. But this case could not be used to justify the fact that this liquidity was maintained for the next decade and a half. The rationalisation of this strange action was that leaving the sea of cash to slosh around the banking system would help the battered and bruised economy recover.
Is there any evidence for this? Not much. The economy remained sluggish. But financial markets went wild. Everything from stocks to classic cars to Rolex watches massively increased in value. The sea of cash never flowed into the economy. Rather it stayed within the financial system itself, bidding up anything that investors could rationally designate as an asset.
All of this started to fall apart when inflation reappeared on the scene and the central banks were forced to raise interest rates. Quantitative tightening, as it became known, demolished bond prices. In 2022, the typical 60/40 portfolio – the workhorse for pension funds everywhere – declined 16pc.
The Bank of England’s own portfolio is in such a poor state that it has had to quietly ask the Government to allow it to raise a levy on the banks it regulates to keep the show on the road. Bond losses for thee, but not for me, the Bank tells us as it seizes what look like quasi-taxation powers for itself.
Yet despite all this we have yet to reevaluate the QE programme. In 1997 we were told that central bank independence would allow the new science of monetary management to be unleashed in Britain. As we move into 2024 the experiments look like they have yielded wacky funny money programmes, grotesque asset bubbles, a seemingly broke Bank of England trying to snatch taxation powers from the King, and, despite all this, a sluggish economy that has recently experienced a painful bout of inflation.
Perhaps there are more things in Heaven and Earth, central banker, than are dreamed up in your philosophy. And perhaps it is time for politicians to ask what dark arts the PhDs are playing with in Threadneedle Street.
