Going "Cold Turkey"

If Jerome Powell truly follows through on his promise to “stay the course, until the job is done”, there could be profound and unwelcome consequences. Not just for world economy, but for the structure of the global financial system, and even the future of democratic societies.

If this sounds alarmist, take time to reflect on how unprecedented, how far from anything close to historic norms, the starting point was. Before this tightening cycle began, global policy rates had hovered between zero and one percent for over a decade. Major central banks balance sheets totalled $35 billion, compared with a mere $7 billion in 2007. Though it reached zero in recent weeks, the amount of global sovereign debt with negative yields peaked at $18 trillion at the end of 2020, well over a third of the global market. Nero zero rates, electronic money printing on an unimaginable scale, and investors paying government for the privilege of owning their debt were things that previous generations could never have contemplated. Indeed, if anyone had forecast that this would happen, they would have ridiculed.

The era of free money lasted so long that it became an addiction. Now, the most aggressive and rapid tightening of global monetary policy in decades is forcing the world to go “cold turkey”. The patient, as we know it, might not survive the cure.

How did we get into this mess?

Central bankers and the economics profession developed an addiction of their own. ?Coupled with supposed “independence” from governments, inflation targeting provided a simple and transparent framework that had solved the age-old problem of sustaining non-inflationary growth, avoiding recessions, and creating an era of perpetual prosperity. Central bankers became media stars, in stark contrast to the faceless and nameless governors of the past. Economists had an endless supply of official statements, “dot plots”, and media utterances to digest and analyse, a far cry from the days when everyone had to guess whether policy had changed, and policy actions were only confirmed long after the event. Not only did very few argue that there were alternative ways of conducting monetary policy, but some also rewrote history, suggesting policy had always operated this way, even if those policy makers of the past didn’t know it at the time.

In short, as time passed, the inflation targeting regime became an institutionalised form of soma. It removed anxiety, self-doubt, made everyone feel happier and wealthier, and provided a solution to every problem. Its only failing was that inflation was a little lower than ideal, a touch below target. Otherwise, Pax economicus had arrived.

The obvious fact that powerful secular forces – globalisation, digitalisation, and aging populations – were critical to inflation remaining low were rarely mentioned. The success was all down to central bankers and the infinite wisdom of the economics profession.

But what few realise is that the defining feature of the free money era was the absence of monetary policy, in the traditional sense. It had effectively become subservient to fiscal policy, thanks to QE, precluding any meaningful degree of policy activism. Policy was aimed at maintaining financial stability, cleaning up the mess when asset price “bubbles” burst. This approach became self-perpetuating. Every time markets wobbled, central banks acted, underwriting the next phase of speculation. The so-called “Fed Put” was the ultimate guarantee for anyone taking market risk.

But, in the end, we always reap what we sow. Inflation targeting had painted central bankers into a corner. When inflation returned with a vengeance, they had no choice but to raise rates aggressively. It didn’t matter what the causes were, or whether rate hikes were the best solution to the problem. Indeed, many in the economics profession derided them for declaring inflation “transitory” and admonished them for their tardiness to act more swiftly. The consequences of going “cold turkey” on the era of free money were irrelevant. Getting inflation back to target was all that mattered and raising rates and reversing QE were the only way to do it.

Despite confident predictions that policy will not only crush inflation but also deliver a “soft-landing”, the fact is we simply do not know the ultimate consequences of such an abrupt end to the era of free money.

Of course, it is possible that Powell might simply be talking tough, seeking to quash counter-productive market expectations of a “pivot". Pandering to the mob, and to politicians. He and other central bankers know full well the risks of their actions, and perhaps the grand plan is to tolerate a slightly higher level of inflation, while avoiding something much worse.

But what happens if inflation doesn’t moderate, or settles at a level materially above the Fed’s 2% target? What do central banks do if a wage-price spiral becomes entrenched??Tighten more aggressively? Could their so-called “independence” survive such a politically unacceptable outcome?

These are the questions not yet being asked.

But if Powell and other central bankers really are determined to get inflation back to target, they could not only be setting themselves up to fail but risking catastrophe on an unimaginable scale. There are three reasons:

1.??????Economic theories of inflation are embarrassingly simplistic;

2.??????Monetary policy is severely limited in what it can achieve; and

3.??????The balance sheet effects of policy actions are impossible to model and will dwarf the direct effects on income and expenditure.

The Problem with Inflation

We all know what inflation is and how it comes about.

Prices go up when businesses figure they can charge more because customers really like their product. Or maybe the cost of raw materials increases due to supply bottlenecks, and customers know this and accept the price increase. Alternatively, governments might increase minimum wages, unions demand pay increases under the threat of industrial action, or the right kind of workers might be in short supply, and businesses seek to pass on these wage increases to their customers. Looked at from this perspective, it could be argued that inflation is an inevitable consequence of the competitive process in a growing economy.

But there is also a more pernicious, destructive type of inflation– typically coined “hyperinflation” - which is much rarer but does rear its ugly head from time to time. This type of inflation stems from debasement in the accepted medium of exchange. Henry VIII infamously mixed copper in with the silver on Tudor coinage, earning the nickname “old copper nose’’. Weimar Germany printed money on a massive scale after the First World War, as did the Mugabe government in Zimbabwe, and many other governments in various countries over the centuries.

Given we all know what inflation is – in both its forms - it may come as a surprise that economic theory has struggled with the concept of inflation for well over a century. Do both types of inflation stem from the same cause? Can one type turn into another? ?How can it be controlled? Is there some “optimal” level?

All good questions. But Walter Heller, chairman of the Council of Economic Advisers under the Kennedy administration, famously said that “an economist is someone who can’t see something happening in practice without wondering whether it can happen in theory”. That pretty much sums up the problem with inflation. It’s a real-world phenomenon, in search of a robust economic theory.

Milton Friedman came up with a simple answer when he boldly declared that inflation is “always and everywhere a monetary phenomenon”. Control the money supply and the job is done. ?But as the monetarist experiment in the 1980’s proved, defining money is very difficult, and controlling it even more difficult.?To use the economic jargon, money is “endogenous” to the financial system, not “exogenous” as Monetarists assumed.

Sadly, too many economists still peddle Friedman’s nonsense in one form or another. While the suggestion that inflation is caused by “too much money chasing too few goods” is inherently plausible, it is simply a motherhood statement.

Of course, this is no secret. Hundreds of books have been written on the fundamental flaws with mainstream economic theory. And the entire field of behavioural economics emerged precisely because the assumptions in orthodox theory about how human beings form their beliefs and preferences, and make decisions, are obviously nonsensical.

But as Max Planck famously despaired on the unwillingness of fellow physicists, including Einstein, to accept quantum theory - “new theories only replace old theories when all the proponents of the old theories are dead”.

Economics has not quite reached that point. Academia is still dominated by general equilibrium thinking, linear models, and absurd assumptions about what constitutes human rationality. And despite years of real-world experience, many central bankers and market economists are still hamstrung by the nonsense they were taught the prestigious American and European graduate schools so many of them attended.

But there is light at the end of the tunnel. Pick up any introductory book on Complexity Science and the first example you will encounter of a Complex Adaptive System (CAS) is the economy and financial markets. Indeed, the Oxford Institute of New Economic Thinking, and the Santa Fe Institute in the US, have been championing Complexity Economics for more than two decades. The BIS has also increasingly been applying the core ideas of complexity theory in their research, despite being hamstrung by the mathematics of their existing models.

CAS’s exhibit many common features, but the most distinctive property is called “emergence”. Emergence refers to the whole being more than the sum of its parts. For example, neither oxygen nor hydrogen is “wet” but combined in the right way they form water. Traffic jams are another real-world example. The volume of traffic is a critical factor, along with the weather, but the behaviour of drivers to the traffic and weather can produce different degrees of congestion.

Emergent phenomena are ubiquitous in nature and once one understands emergence, everything we see happening in economies and markets make sense, not just now, but throughout history.

The current resurgence in inflation is a classic example of an emergent phenomenon. If you look at history through a complexity lens, the same can be said of inflation in the 1970’s, and other inflationary episodes. Hyperinflations are obviously emergent. It is only our collective belief that makes a banknote worth something. If we collectively decide the money in our pockets is worthless, then it is. Yuval Noah Harari persuasively argued in his best-selling book “Sapiens” that we became the dominant human species because of our ability to construct “imagined orders” – things that do not physically exist, except in our collective minds.

The dynamics behind the emergence of the current inflationary episode are well known. The pandemic provided the spark, with lockdowns interrupting global supply chains and China’s ongoing Zero-COVID policy perpetuating these disruptions.?The war in Ukraine, sanctions, and myriad other factors subsequently put upward pressure on commodity prices globally. Wage pressure had been building for some time in the major economies, partly due to shrinking workforces, and partly due growing intolerance to persistent and worsening income inequality. But the recent industrial unrest and outsized pay demands have been fuelled by inflation printing higher and the squeeze on the cost of living. Finally, for decades businesses have been reluctant to put up prices, even after the secular disinflationary forces of globalisation and technological advancement began to wane. Now it is open season for price hikes. Our collective behaviour has shifted.

Will central banks be able to short-circuit this shift in collective behaviour? Will they be able to convince us that inflation is going back to target? Will recession, rising unemployment, bankruptcies, and the other consequences of such a sharp rise in rates, bring us all back to our senses?

Unfortunately, our collective behaviour does not have to follow the rules of the economic model in the heads of central bankers and professional economists. We determine how economies and markets work, not them. Take a brief look back at economic history if you need convincing.

The Realities of Monetary Policy

The simple truth is that central banks cannot control anything. All they can do is influence the degree of leverage in the global financial system, or seek to manipulate the price of government debt, either through outright purchases (i.e., QE) or jawboning markets (i.e., Forward Guidance). Andrew Bailey said as much when grilled by a parliamentary committee in mid-2022. Mervyn King’s memoir, “The End of Alchemy, similarly warned about the way policy had evolved. Other former central bankers have expressed similar sentiments once they had moved on to other things.

How this ability to influence the degree of global leverage might eventually feed through to the pricing behaviour of firms, wage demands, and so on, is an enigma wrapped in a conundrum. The “transmission mechanism” through which monetary policy impacts inflation has always been uncertain and time-varying, even when markets were regulated. The complexity of the world economy and global financial markets today is unquestionably not amenable to simple and consistent relationships between policy actions and outcomes.

For this reason, since the early 1980’s, the “anchoring” of inflationary expectations has been a key focus of policy makers, hence the experiments with money supply targeting, and in some countries exchange rate targeting (e.g., New Zealand), before the current regime of inflation targeting was widely adopted in varying forms. An accepted “nominal anchor” is the holy grail for central bankers as it guards against both types of inflation. The Gold Standard and Bretton Woods served this purpose for a time, until geo-political events undermined them.?The current inflation targeting regime might end up suffering the same fate.

The impact of monetary policy on economic activity is less uncertain than the impact on inflation. If your bank offered you an unlimited overdraft and promised never to ask you to pay it back, you would “spend, spend, spend” until they changed their mind. Lower interest rates and QE are always expansionary and higher rates and QT are always contractionary. As we saw in the era of free money, higher leverage and ever-increasing indebtedness does not necessarily result in persistent price rises for goods and services but does lead to higher growth and rising asset prices.

All central bankers know that monetary policy is very much more art than science. But in the long period of low inflation, the dangerous simplicity and seductiveness of the inflation targeting regime had a bewitching effect. Wrapped in the myth of “independence”, every decision and every utterance had to be consistent with the framework. This has meant that while inflation remained low, politicians, bankers and market commentators would have publicly crucified any central banker for raising rates to more sensible levels, even though some within the central banking community, particularly the BIS, argued strongly for this to be done.

The direct and behavioural effects of decades of low rates and money printing cannot be unwound in a matter of months. It is unlikely the behaviour of governments, businesses and consumers will suddenly change because of higher rates, threats of higher unemployment, and self-righteous lectures about wage restraint. Hamstrung by the fiction of being able to control inflation, central banks are playing the only card they can play, crossing their fingers, hoping the problem will go away.

Its all about the Balance Sheet

Credit creation is a remarkable thing. People borrow money to buy some asset, its price goes up, their collateral increases, so they borrow more. If the price goes up again, they might borrow even more. And so on. When the price goes down though, they get called for more collateral, and when they run out of collateral, they go broke. They leave the economic game. To use the term coined by Nicholas Nassim Taleb, they reach an “Uncle Point,” where a relative houses and feeds them.

Every major financial crisis has featured an unwinding of excessive leverage of some form, and a vicious cycle of deleveraging. The crisis in the UK Gilt market being the most recent example.

Macroeconomic theory focusses on the real economy, specifically the fluctuations in real income and expenditure over time. Obviously, economists know the balance sheet exists, and often figure out ways to take account of the level and changes in stock of debt and assets on spending and income. But balance sheet effects are considered on the side, by adding a wealth variable, or by tweaking a parameter here and there on spending equations. They are not integrated. This is because the Dynamic Stochastic General Equilibrium (DSGE) models used for forecasting and analysis have no financial sector.

The problem with treating balance sheet effects as an add-on, or a side show to the real economy, is that the reverse is true. But there is no alternative because the assumption of the existence of a general equilibrium that underpins all economic theory and DSGE precludes anything, like credit creation, that is mathematically unbounded. Discontinuities, like going broke, are also not allowed.

Again, this is no secret, but it is certainly an embarrassment that central bankers and most economists frequently, perhaps conveniently, overlook.

Though extraordinary difficult to measure, the stock of debt and of real and financial assets could currently be c. 12 times larger than the flow of income and expenditure. This is a rough guess. But in his famous book, “Capital in the Twenty-First Century,” Thomas Piketty estimated it was 8-9 times larger in 2010, and the balance sheet has grown much faster than the economy since then.

When the balance sheet is so many times larger, small changes in asset prices and asset allocations can have large effects on income and expenditure. Contrary to the myth perpetuated by many economists, and especially the financial media, that asset prices respond to changes in so-called “economic fundamentals”, the causation has always run both ways.

Since central banks embarked on a tightening cycle, they have produced estimates of how exposed households are to higher rates, looking at proportion of loans on fixed versus floating rates. They have also looked at corporate balance sheets, and timing of debt rollovers. This analysis might have some value and might prove to be reasonably accurate. But when one is able only to look at first-order effects on individual sectors, the potential for much more serious outcomes is far higher. First-order effects in one sector will create second order effects in others, and these second order effects will interact to create third and higher order effects. ?In a Complex Adaptive System, second, and third order effects are potentially very large.

The BIS in its latest annual report highlights the financial vulnerabilities created by the era of free money. Government, households (particularly low-income ones), and non-financial corporation debt remain close to all-time highs. After a long period of expansion these should have declined. Banks are better placed than they were in 2008 but remain vulnerable to material falls in house prices and credit card defaults.

In short, even a high-level examination of the balance sheet warns that a “soft landing” for the world economy is a low probability event. A deeper look is difficult, given the complexities and data available, but it would no doubt paint an even bleaker picture. This should not be a surprise. What else would you expect when such an extraordinary era of free money is so rapidly reversed?

Where to Next?

We know that inflation will likely print lower over the year ahead, due to base effects, commodity price pressures reversing, and supply chain disruptions easing.

But even if inflation pressures do lessen, the secular forces that created the great disinflation – globalisation, digitalisation, and aging populations – are in reverse or weakening.?Climate change mitigation and adaptation, declining populations in developed countries, and the political and societal need to address current extremes in wealth and income inequality are the secular forces that will shape the world for at least a generation. All these forces are re-inflationary, not disinflationary. Precisely how much higher inflation will average is anyone’s guess, but the direction is clear.

The outlook for the world economy and asset prices is bleak. Equity and house prices have much further to fall. Markets will eventually give up on a “soft landing”, and more downward serious price moves are likely, in contrast to the slow grind down seen to date.

When reality hits home, central banks will almost certainly “pivot”, because they are acutely aware of the dangers of what they are doing, and the political pressure they will face will be on a scale not yet experienced. So-called "independence", always exaggerated, will cease to exist. ?

As for monetary policy, current thinking will evolve, as it always does, and the conduct of policy will subtly shift. That is how it has always happened in the past.

Will it be more activist? Will it go back to its roots and focus on avoiding excessive credit creation, upending the philosophy of the Bernanke era? Will taking away the “punchbowl” and punishing speculation come back into fashion? We will have to wait and see.

For investors, the greatest challenge will be to unlearn. All the old rules were broken in the era of free money and non-existent inflation. They will be broken again and eventually replaced by new rules. So, if your investment or trading strategy is based on a Fed “pivot” causing some sort of mean reversion in market behaviour, a return to free money era “normal”, good luck. You will need it.

The Future Fund in Australia recently issued a paper called “The Death of Traditional Portfolio Construction?”. The high-level conclusion is that portfolio resilience will be critical (i.e., avoid losing capital) and require robust diversification, not simply slicing and dicing asset classes, with the same sources of risk. ?My take on the key ideas is that:

1.??????Alpha will be critically important;

2.??????Regional and country exposures will require more focus than bloc exposures (e.g., EM vs DM)

3.??????New forms of defensive assets will be required, including cash; and

4.??????Asset allocation will need to be more dynamic, and portfolio shifts more meaningful in size.

In simple terms, the era of relying primarily on market beta to meet return objectives is over. Warren Buffett’s first and second rule of investing came to mind when reading the paper – “don’t lose money”.

In terms of geo-politics, the 21st century was always going to see a profound shift from West to East. Regionalisation will be the trend rather than globalisation. Events in Brazil in recent days, on top of the political circus in the US Congress, should remind all of us, that the populist right has seen its influence weaken but will remain a powerful force for some time to come.

Everyone will be poorer in the aftermath of what central banks are doing, but it will no doubt worsen income and wealth inequality. When asset prices fall, and debtors’ default, those at the bottom of scale lose everything. Poverty and anger breed extremism, which is why this abrupt end to era of free money will be a serious threat to democracy.

Time to be Philosophical

When the history of this period is written, and people look back at the free money era, they will be puzzled by its stupidity. How could anyone think electronic money printing on such a scale was sensible? And why would anyone buy government bonds with a negative yield? Madness, future historians will conclude.

We should not forget that this what always happens, and always will. Humanity collectively embraces stupidity on a regular basis.

But there is a positive. Our optimism that things will always work out for the best, and our willingness to believe fantastical stories, also leads us to pursue bold ideas and achieve great and amazing things. The turmoil which lies ahead, is long overdue, and will make for a better future. Capitalism is about creative destruction, not perpetual prosperity.?