What has been most frustrating to investors in this entire process is that these central bankers seem to be ‘learning on the job’ as they so quickly pivot from one scenario to another and shake the confidence of investors in the process.   Let’s take a short walk back in terms of their commentary.  Less than two years ago the Fed re-iterated many times that they were “not even thinking about thinking about raising interest rates anytime soon and definitely not prior to 2023.”  Then last year they claimed that the inflationary surge we were all seeing was “transitory” and that inflationary pressures would soon subside as supply chain blockages loosened.  In fact, they indicated that they were willing to let inflation run “moderately above” their stated 2% target rate for a period of time since they wanted to make sure they had avoided going into a deflationary spiral.

Now the only policy that central bankers seem to have is to jam interest rates up high enough and fast enough to cool down inflationary pressures, potentially sending the global economy into recession.  Once again they seem not to be reading the proper playbook.  Monetary policy is often referred to as a ‘blunt instrument’ as opposed to a ‘precision tool.’  In that regard, we note that central banks have moved more aggressively than they ever have in the past year to tighten monetary conditions and they should probably at least take a ‘pause’ to see what the impact of these rate increases has been before continuing.  Monetary policy works with a ‘lag’ so we may not have seen the impact yet of the rate increases already in place.

To see how central bankers have gotten to this position we need to step back and look at the big picture and history in some more detail.  I did graduate studies in economics at University of Western Ontario in the 1970s, where the core economic professors were disciples from the early days of ‘monetary theory’ as developed and espoused by the Chicago School of Economics and one of their leading teachers, Professor Milton Friedman.  The whole basis of this theory is that money supply is ultimately the largest predictor of price behaviour.  We remember the famous quote “inflation is always and everywhere a monetary phenomenon.” That seemed almost too obvious to decree that the amount of money printed controlled ‘inflation’ AKA the ‘price of money.’   Cynics underplayed the theory, joking that it was like saying ‘the price of pencils is always and everywhere a pencil phenomenon.”  Point taken, but it was also the theory that dominated policy behaviour of central bankers over the next three decades.  Most importantly, the policies seemed to be working.

Fast forward decades later to the Financial Crisis in 2008.  With the collapse of mortgage industry in the U.S. weighing on the entire global banking system and hence financial markets as well, central bankers and policy makers came together to put together a massive US$700 billion financial rescue package.  Interest rates were also cut to near zero to encourage borrowing and spending and, in fact, in many countries in Europe as well as Asia, rates actually went negative.  The concept to most investors of ‘locking in’ a 10-year total rate of return of Negative Five Percent seemed ludicrous but that was the policy.  In fact, as recently as two years ago, over US$10 trillion of global debt carried negative interest rates.  Certainly this policy had nothing to encourage savings but that was the plan.  Central bankers wanted to encourage borrowing and spending to spur the global economy to a recovery.   And it worked, to some degree.  Economic growth did recover.  In fact, it seemed to work so well that the profession is recognizing this success as ‘’then Federal Reserve Chairman’ Ben Bernanke is among a group of economists who recently won the Nobel prize in economic sciences for some of the policies put in place at that time.

More importantly, inflation did not result from this massive expansion of the money supply.  Was Friedman wrong after all with all of that ‘monetary theory?’  We have wondered that a lot watching the ridiculous level of money growth over the past decade without any consequent result of higher inflation.  But the problem was that the excess liquidity was all being channelled into financial assets rather than the real economy.  We did have inflation from all of this money creation, but it was all in financial assets.   Funny thing is, no one calls it inflation when it is in financial assets; they call it a bull market and investors don’t complain about that!  Regardless, central bankers felt empowered as they had found policies that could rescue financial markets without any consequences.  It wasn’t just in the U.S. either.  Shinzo Abe and his predecessors had been running similarly loose policies in Japan for decades without any inflationary impacts.  And who could forget the famous quote from ECB Chairman Mario Draghi following the Greek economic crisis and the near resultant breakdown of the EC when he said he would do “whatever it takes” in terms of policy to get growth back.

Fast forward once more to 2020 and the Covid pandemic.  Central bankers were confident that their ‘monetary ease’ experiment had worked so well in the Financial Crisis that they should go ‘back to the well’ and try it again to help the global economy recover from the brutal pandemic shutdown.  In fact they ‘doubled down’ somewhat on the monetary ease in 2020.  Not only did they cut interest rates right back to zero, they also instituted a program of ‘Quantitative Easing’, wherein central bankers became massive buyers of government and mortgage debt, to the tune of over US$100 billion per month by the US Federal Reserve.  That helped to keep longer term interest rates low as well.  But due to the shutdown of the global economy and supply chains that had become so critical to global production over the prior three decades, production of many core goods was curtailed.  Prices of those good soared and we ended up with the worst inflation in four decades.   The monetarists did have it right after all!  But now central bankers are headed completely in the other direction and seem ready to drive the global economy into recession to ‘break the back’ of these inflationary pressures.   We hope they all step back soon and see what the impact of the policies they have already put in place have accomplished.  The global economy was extremely ‘levered’ after over a decade of ‘near zero’ interest rates, so they need to take their time and assess the economic situation before taking further aggressive action, otherwise they risk a true ‘financial accident.’

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