31/05/2023
(It’s time for the second part in our series, where we ask our Chief Analyst Neil
Wilson what he really thinks about the major stories in the markets right now.
This week, we got him on a serious roll talking about central banks and their goal to
reach a specific economic target… no matter the consequences…)
“And all at once it seems so nice/The folks are throwing shoes and rice/You hurry
to a spot that’s just a dot on the map/You’re hooked, you’re cooked/You’re caught in the
tender trap.” Frank Sinatra, (Love is) The Tender Trap
Bank of
England’s chief economist Huw Pill caused a mini meltdown on social media a couple of weeks
ago by suggesting that we all need to accept that inflation has made us poorer: “… what
we’re facing now is that reluctance to accept that, yes, we’re all worse off, and we all
have to take our share.” Last year, BoE governor Andrew Bailey did a similar number on
his own public reputation for suggesting that he wanted to see “restraint” in pay rises for
British workers. “I’m not saying nobody gets a pay rise, don’t get me wrong. But what I
am saying is, we do need to see restraint in pay bargaining, otherwise it will get out of
control.” I could make some kind of remark about Bailey’s own ‘restrained’ 2020-21
salary of £575,538. I won’t, obviously. (I’d never be that petty.) And anyway, bank
officials making everyone hate them again isn’t the interesting story here. What you should
be focusing on is the very obvious trap central banks have spent the last year or so walking
into. A trap that could, putting it mildly, have serious consequences for you, me and anyone
else with bills to pay. Let me show you why…
Simple cause and (underwhel
ming) effect
UK inflation remains relatively
depressing to look at: Figure 1. Inflation at 10.1% in March 2023
Source:
Office for National Statistics
As I write this in mid-May,
we’re still sitting at a 40-odd year high. So far, so bleak. “But Neil, there’s been a
decrease this year,” you might argue. And you’d be right. Sort of. The problem isn’t
that inflation isn’t falling. It’s that it’s not falling in line with how much
we’ve already done to fight it. You probably know that the key tactic central banks use to
fight inflation is by raising interest rates. And boy, has the Bank of England been
fighting, albeit after a slow start. March’s interest rate hike up to 4.5% was the 12th
increase in a row. The last time we had interest rates this high was before the
global financial crisis. That’s a lot of hikes in a short space of time. Remember, as
recently as December 2021, interest rates in the UK sat at 0.1%. You can’t say the
BoE hasn’t gone all out to bring inflation down. They really are trying. But what have they
actually achieved? The answer is, not a lot. “Why are UK food prices
still rocketing and when will it stop?”
The Guardian
“[The
UK economy] grew by just 0.1% between January and March…”
BBC News
“UK
inflation is just not going down as cost-of-living crisis offers ‘no respite’.”
CNBC.com
And an
inflation rate that’s fallen from 11.1% in October last year to 8.7% in May. Whoop de do,
Basil. A 15-year high in interest rates should be killing inflation. At best,
they’re giving it a slight nosebleed. Look across the pond, and you’ll see a very similar
situation. The Fed has raised rates to between 5% and 5.25%, and core inflation in the
States is still basically hovering just below 5%. So, let’s ask the question no-one really
seems to want to answer right now.
Inflation in the black…
what if it’s never going back?
2% has been the
accepted inflation target since 2012 in the US. Here in Britain, it goes back further, to
1992. Laurence Ball, professor of economics at Johns Hopkins University, once quipped that “maybe
somewhere in the Bible, God says he wants 2% inflation.” (Actually, the origins are the
Reserve Bank of New Zealand, who first introduced an inflationary target in 1989.) Jokes
aside, the 2% target feels like it’s been around forever. And, to be fair, we did enjoy a
good two decades of (generally) low and stable inflation after the target was introduced,
and no-one really seemed to have any strong opinions about it either way. But it’s taken
less than a year of higher inflation for the questions to start creeping in: “Should
central banks ditch the 2 per cent inflation target?”
Investors Chronicle
“Should
central banks’ inflation targets be raised?”
The Economist
“Does
it make sense to ditch the 2% inflation target?”
Schroders
The idea of
raising the inflation target has become a major talking point mighty fast. Both the Fed and
the Bank of England have already had to issue statements on the idea. BoE chief Andrew
Bailey re-iterate the bank’s “determination to push consumer price inflation down from
10.1% in March this year to the 2% target”. No beating around the proverbial privet.
Fed chairman Jay Powell at least attempted a bit more of an explanation: “We think it’s
really important that we do stick to a 2% inflation target and not consider changing it.”
“The
modern belief is that people’s expectations about inflation actually have a real effective
on inflation. If you expect inflation to go up to 5%, it will.” His argument is all
about perception. The principle is simple enough. If you set the inflation at 5%, the idea
of 5% inflation will become more widely acceptable. Once you’ve anchored people to a high
inflationary environment, it can be very tough to anchor them back again. Or, more simply,
it’s tougher to get the genie out of the bottle once you’ve let him out. Of course,
inflation is already at 5%.
Caught between Scylla and
the deep blue hard place
Raise interest rates
quickly, and people – and more importantly, businesses – spend less. They borrow less, too.
Companies struggle. They make cuts. They let people go. They fail. Less jobs, more
unemployment, no growth… A recipe for a suffering economy, in other words. This puts
central banks in a tricky position, as the World Economic Forum put it:
“Central banks now face a trade-off between, on the one hand, persisting with the pact
of their tightening cycles until inflation is back down to more manageable levels, and on
the other hand, doing anything that might trigger further distress in the financial sector.”
In other words, they’re trapped. Name your cliché: Devil and the deep blue sea… Scylla and
Charybdis… Rock and a hard place… Take your pick. It won’t make a difference. Britain is in
one tough position right now. UK growth in Q1 of 2023 was 0.1%. Our economy is already
moving at tortoise pace. More than a quarter of mortgage payers will be at risk of default
by the end of 2023. Food bank use is at an all-time high… So… Does this seem like a country
that’s ready for another hike to interest rates? It doesn’t seem that way to me. And it’s
not just about Britain, there’s a much bigger global problem lurking here…
“The debt’s the thing”
Global debt is more than three
times higher than it was during the ‘disaster’ stagflation years of the 1970s. At
the start of 2023, global debt hit an all-time high of $300 trillion. That’s the equivalent
of $37,500 for every single person on earth. There is more debt in the financial
system now than at any point in history. And guess what happens if you start to crank
interest rates on the highest levels of debt in history? You know what? You don’t have
to guess. Credit Suisse happens. First Republic Bank happens. Silicon Valley Bank happens.
Sure, you can say that these banks were badly run and made stupid decisions. You wouldn’t be
wrong. But we’ve only hit interest rates of around 5% so far… And the hikes are already
doing more damage to the banking system than they are to inflation. What happens if
the Fed or the BoE really try to force inflation down to 2%? Just how much higher would
interest rates have to go? Or, in other words… What price are central banks willing to pay
to hit that magic number again? A long recession? A new depression? A mass failure in the
banking system? Or… Maybe they’ll take a chance, raise the inflation target,
encourage growth… And accept that in the short-term, we will all be poorer. Either way, pay
attention. It’s our money they’re playing with. All opinions, news,
research, analysis, prices or other information is provided as general market commentary and
not as investment advice and all potential results discussed are not guaranteed to be
achieved. The information may have been derived from publicly available sources, company
reports, personal research, or surveys. Past performance is not indicative of future
performance. Trading carries risk of capital loss. Service available to professional clients
only.