Reports on both sides of the Atlantic of ending the current cycle of monetary easing as a central policy option were probably a smoke screen to cover up the poor state of the financial system.
The analyzes that are circulating refer to the prospect that the Fed and the ECB return from the spring of 2024 to their old favorite practice of reducing interest rates, to the “cheap money” that caused the inflationary havoc we are living. Although central banks are praised for their independence by policy analysts, this is nothing but a huge delusion.
The bigger picture of the situation suggests the opposite of this big financial media propaganda. In the financial aftermath of the pandemic, monetary policy was equally under tight political control. And, in both the US and Europe, central banks were mandated to ease credit conditions in order to achieve a slowdown in consumer price inflation.
The truth is that they have taken advantage of the supply chain boost caused by the pandemic’s weakening supply chain problems to achieve persistent – but now partially camouflaged – monetary inflation, the devaluation of money.
Consumer prices would have fallen to pre-pandemic levels if sound money prevailed and central banks did not print dollars or euros to serve the electoral clientele of the rulers. Some old symptoms—and some new ones, too—of asset value inflation over the past year or so highlight the reality.
The electoral cycle and central banks
A series of rate cuts before an election is not necessary for a shift in monetary policy with an eye on the polls, although a few spectacular episodes stand out in the history of similar situations.
The most infamous was the Fed’s policy under Arthur Burns in the run-up to Nixon’s re-election in November 1972, which a year later led to the start of the stock market crash and recession. Less highlighted in the history books—but just as infamous in reality—was the easing cycle in the run-up to the 2004 US election.
This started with President George W. Bush when he appointed the famous neo-Keynesian Ben Bernanke as Fed governor in October 2002 whose main policy was to deal with inflation and then proceeded to extend a half term for Alan Greenspan.
The result: The monetary policy followed was strongly oriented towards “cheap” money in order to stimulate the growth of economic output. A fact that is proven by the interest rate reductions to unusually low levels for that period.
Continued rapid productivity growth driven by the IT revolution and a globalization boom centered on China helped keep inflation low at least until Election Day. The Great Depression was just over two years away.
The political decision and central banks
The current political cycle in monetary policy is not solely rooted in interest rate cuts to unusually low levels.
What was the political decision? Perhaps the big implicit political decision in monetary policy was to “lock in” a huge loss of purchasing power of money during the pandemic while an inflationary boom was underway.
Accordingly, the dollar and euro by the end of 2023 had lost 17% and 15% of their purchasing power since the end of 2019.
What is behind these targets?
The most important clues come from the silence on all sides about key considerations. These include facilitating an increase in government spending while imposing a huge depreciation of income and assets (which in effect acts as a huge tax grab)—at the cost of keeping the real value of public debt below a trend line steep rise. Both central bank governors and political leaders participated in this decision-making.
The Fed’s Strategy
Central bankers appear adamant that they pursue an anti-inflationary policy. They point to high nominal interest rates and “normalized” real yields in the TIPS (Treasury Inflation Protected Securities) market. Treasury inflation-protected securities (TIPS) are a type of bond issued by the US government. Index-linked securities the UK counterpart.
TIPS are adjusted for inflation to protect investors from a decline in the purchasing power of their money. As inflation increases, instead of their yield increasing, TIPS adjust in price (amount of principal) to maintain their real value.
The interest rate on a TIPS investment is fixed at the time of issue, but interest payments keep pace with inflation because they vary with the adjusted principal amount.
They do not sound the alarm that nominal interest rates are a notoriously inaccurate guide to monetary conditions, or that market practitioners know that real returns in the TIPS market can be much lower than underlying real returns after adjusting for liquidity premiums (premia).
They also urge us to ignore distortions in the calculation of the CPI and possible future removal of indexation clauses.
In the case of US Fed chiefs, the re-appointment of chief Jerome Powell in early 2022 is an important element of the response. White House and Senate officials no doubt understood that these individuals would not deviate from the politically convenient path—especially when a massive increase in fiscal spending was underway.
In this context there is no compelling reason for the Fed to cut interest rates now. A cut may come in the middle of the year to symbolize the triumph over inflation and a perfect soft landing.
Implicitly the political calculation was based on the assumption that voters would not question the triumph over inflation – something that remains to be seen in practice.
Voters are supposed to ignore the cumulative loss of purchasing power of their money since the pandemic, even though some polling data suggests otherwise. Central banks print money – INDEX M2.
The situation in Europe
In the case of Europe, the monetary cycle and the political cycle are determined by Germany.
The power to appoint the head of the Fed has played a key role in exerting political influence on monetary policy. Already in the twilight of her government in 2019, Chancellor Merkel threw her support behind Christine Lagarde to head the ECB instead of backing Bundesbank President Jens Weidmann, who took a harder line on monetary issues.
This corresponded with her party’s ultimately failed strategy, the CDU, to claim votes from the pro-European Center Left rather than the Far Right. Then, in late 2021, new Social Democrat Chancellor Olaf Scholz named Joachim Nagel—the deputy head of banking regulation at the BIS—as Bundesbank President rather than choosing an academic follower of traditional German monetary policy.
German general elections are scheduled for 2025, but could be held earlier amid the current crisis in budget financing negotiations between government coalition partners and the issue of the constitutional debt brake. The upcoming elections have an influence that we need to account for in order to explain European monetary policy.
The big challenges for the current coalition partners (SPD, Greens, FDP) include the wave of the Far Right (ADP) and a new populist party on the Far Left.
As such, Berlin is still messaging the traditional German respect for hard money so as not to upset voters nostalgic for the days of the comparatively tough Deutsche Mark. Consequently, there is no sense in any rush to cut interest rates.
Every head of the ECB, including the current ex-politician Christine Lagarde, knows how to exercise skillful diplomacy in the political corridors of Berlin – so fundamental is Germany to the continuation of the European Monetary Union.
The two alternative scenarios
As the apparent resistance on both sides of the Atlantic to early rate cuts develops, there are two alternative key scenarios to consider.
1. The first is an endogenous accumulation of crisis elements within economies.
2. The second has asset value inflation gaining momentum.
Based on the dynamics of monetary policy, the interest rate cut would come in response to any substantial perceived rapid depreciation of asset values.
The lessons of the delayed effective response to the “credit earthquakes” that began in the spring of 2008 are familiar to today’s monetary policy makers.
The invisible credit earthquakes
So far, however, in early 2024, there are no apparent earthquakes, but problems at small non-systemic banks in the US, Germany, Switzerland and Japan. Increasingly, the problem has been the involvement in bad loans in commercial real estate with much of the horror story in the US being office real estate.
The second counter-scenario, characterized by strong asset inflation, would produce no action at all. Poisonous inflation in asset values would appear as new profit opportunities in major market sectors along with a stunning further rise in credit markets.
This build-up in asset inflation could be accompanied for some time by the continued decline in the Consumer Price Index. This would likely be a long-lagged precursor to the other symptom of monetary inflation: rising real consumer price inflation. The rationale would be against any preemptive response.
In short, current monetary policy as it is driven by the political cycle could trigger a relapse into runaway inflation followed by a fiscal crisis, perhaps well beyond the upcoming election and with particularly disastrous results.
Or, alternatively, deflation in asset values could occur before the election and bring an immediate and strong monetary response. The extent of present and future monetary inflation and the timing or extent of asset price inflation or deflation are—as always—a matter of speculation.
What is certain, however, is that central banks feed the positive narrative of policies for the economy, as if they were not due, while the fiscal derailment and the inflationary nightmare are just around the corner.
