The three things investors should know this week:
US jobs data have thrown the central bank’s decision to cut rates aggressively into question. Inflation risks further rise due to geopolitical tensions, even as the global economy slows.
How should investors view this? For one, they should accept that in a post-QE economy, many more opinions will be heard, and positioning around monetary policy and its outcomes will become more spread.
Meanwhile, investors should be mindful of the threats to central bank independence, especially if inflation resurges.
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mission creep (noun)
a gradual shift in objectives during the course of a military campaign, often resulting in an unplanned long-term commitment.
(source: Oxford Dictionary)
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The main objective of central banks is to curb inflation. But what is the mission in a world that deflates? Does one cease to care, or do they expand the job?
A theme we have long elaborated on is the “return to normal investing”. But what does that mean? For one, it means more voices in markets and economies.
Last week, strong jobs and inflation data out of the US threw into question the American central bank’s decision to cut rates aggressively a few weeks ago. The US economy created 272,000 new jobs in September, about 100,000 more than expected.
Meanwhile, salaries were also strong.
As a result, expectations for year-end rate cuts were somewhat diminished.
Did the world’s most important central bank get it wrong when they said that they would perform a double cut because they were worried about job market weakness?
Inflation risks are rising as Middle East tensions are close to the edge of what can be reasonably described as “a controllable situation” that the markets have any hope of pricing in.
Or was the Fed simply cognisant of weaker growth conditions, which last week’s PMI data also warned us about?
Was Michelle Bowman right to become the first Fed board member to dissent in nearly two decades? Was Hugh Pill, the Bank of England’s Chief Economist right to contradict his boss’s optimism that rates can come down faster? Are the ECB hawks right to warn that inflation still needs to be checked?
Before we answer this, let’s take a step back.
In the past two decades, central banks could, and would, solve most problems in the world by printing and throwing money at them. That was not their mission, however. It was, as all “mission creep”, going above and beyond. Markets learned to depend on that money. Whenever they would throw a fit, it was expected that the central bank would be there to protect them. Their political masters learned to rely on them too. It became easier to keep fiscal expansion in check and heed a universal demand to curb debt after global banks nearly collapsed in 2008, as lower market volatility would avert economic crises. The top 10%-20% of the developed world, those who own stocks and bonds, were happy, as the prices of risk assets soared. Some of that money found its way into the real economy, which somehow kept chugging along. Central bankers would meet 2-3 times a year, in Davos, Jackson Hole and a couple of more places, they would agree that money costs could be kept low in an inherently deflationary world, and that was it. Four or five people held the keys to a synchronised global economy.
The increase in economic inequality (not everyone owns financial assets) and the chronic misallocation of capital due to persistently low rates fanned the flames of resentment of the status quo, and political populists promised to fix the problem. Whether they would “occupy Wall Street”, “drain the swamp”, “punish the elite” or expel migrants they were riding a wave of resentment over an economy that was somewhat functional on average, but clearly more so for some than others. As a senior colleague once told me, “George, Americans got jobs, but they don’t particularly like flipping burgers”.
Central bankers took it upon themselves to fix the world after Lehman closed its doors. But the job proved too big, many were unhappy, politicians were getting envious and intrusive and, worst, they seemed to be stuck doing it longer than they had anticipated. As any action hero in any (decent) movie ever shot would attest, saving the world can be a pretty thankless job. Consensus as to what a “saved” world looks like simply does not exist. With the possible exception of Alan Greenspan, the father of modern central banking, many central bankers are toe-line technocrats. Not many are naturally inclined to chase the spotlight.
The resurgence of inflation after the pandemic ended both the ability and, more importantly to them, the obligation to save the world. After nearly two decades of unimpeded control of the world’s stock and bond markets, central bankers are finding themselves back to their original mission, trying to put a lid on inflation. But this means difficult decisions, essentially balancing growth, politics and prices at supermarkets.
The transition to normality is causing friction and disagreement.
And that’s what normality looks like. Shocking as a dissent might have been in a “forward guidance” era, it actually happens at 6% of the votes, or more than 450 times since 1936. It still become the world’s most important central bank. In the Bank of England, non-board members regularly dissent on monetary policy, yet overall decision-making is still good. Should economists, like Hugh Pill, dissent from their bosses and express doubts? They are known for little else. As are, mostly inflation-fearing German policy hawks in the ECB. But that’s exactly what normality should look like.
Normality is primarily about plurality of opinions, and of market positioning. Much like the bi-modal positioning ahead of the US elections, investors are increasingly positioning themselves for a multitude of monetary policy outcomes. And this is inherently good, as it allows active managers to reap more profits when they are right (and be judged more harshly when they are wrong). We might have forgotten the virtues of plurality during the crisis years (polyphony can be construed as cacophony when the world comes crashing down around you) but at a time when central bankers shy from previous market manipulation practices, a modicum of dissent should be allowed, if not directly encouraged.
However, we must not forget that dissent does come with risks. Central banks are at a crucial point in their history. Their independence, the basis of their operation, is coming under scrutiny. With it, their ability to slow down (if not control) inflation. Central bank independence, a concept that arose in the late 1970s after a miserable decade of experimenting with monetarism, aimed to control inflation by separating the need for short-term nominal growth at any cost (a state goal) and the need to keep the poorer from suffering due to surging prices.
But the Central Bank consensus, which provided political cover and immunity so that central banks could operate independently, is being exhausted. In a world that is slowing down in real terms, due to increasing debt burdens, poor demographics and geoeconomic fragmentation complicating supply chains, an organisation of unelected individuals with the power to slow down nominal growth can become a target for politicians who seek to consolidate power. If inflation is all about the supply side, what is the use of curbing demand, one could argue. Policy errors or dissents may be viewed in the light of incompetence, especially if price pressures persist.
Is political acrimony over venerable institutions part of the “new” normal, something to get used to? Or is it a “phase”, a part of a run-of-the-mill populist cycle that will pass? That is the question that needs answering more than any. Whether dissent between economists and policymakers is normal or not.