The Economic Cancer that is Inflation. ... and why central bankers cause it, then fight it, then cause it again.

Many people, including serious economists, really fail to understand for a second why Central Banks actually fight inflation when it moves above their target levels.  I sometimes suspect that without a mandate to follow that told them to fight inflation, central bankers themselves often do not know.  

I am not a huge fan of professional economists or the studies they do.  I am not generally a huge fan of putting people who were quite possibly so poor mathematically that they could not study a second unit of mathematics in their final school years in charge of the economy.  

I have little doubt that the reason central banks and regulators failed so abysmally in the run-up to the GFC is inextricably woven with rather faux intellectualism claims from the economics faculty, and a lack of hard mathematical ability.  On the other side of that debacle of course were the exotic products quants who were busy originating mathematically arcane products with fatal tail risks, in the presence of no effective regulation or surveillance.  The flip-side of that coin, the failure to preserve the slightest mirage of underwriting standards in credit origination likes squarely on regulatory culture.

However, it is true that a concerted and desperate effort was made as the GFC burgeoned to essentially save western banking systems with very very radical and extreme monetary policy.  I personally found those decisions unconscionable at the time because of what they were always going to cause later, sowing the seeds of the disaster we will now have.  They were doubling down on disaster and kicking it a busincss cycle down the road.  Well, nature intervened with covid and they did not quite get a business cycle even.  They had to fire the fiscal cannons in 2020.

There is a fundamental economic tradeoff between inflation and growth.  We have known of it for centuries.  When you set rates too low and supply too loose for too long, disaster is with you soon enough.  The policy rate and money supply is the signal, and the economy will eventually dance.  Further, to unleash a torrent of fiscal cannons after running monetary policy too loose and low for fully 25 years was simply folly at its fullest.  A necessary folly and unconscionable not to this time around on the fiscal side, but it was always going to light the fire.  That fire had been smouldering in the long grass since 2012 roughly.

The only thing holding back the fire was tight fiscal policy matching loose monetary policy and a certain short-term risk aversion that prevented quite the same level of risk seeking with leverage that we had seen from 1998 to 2008, but there was plenty of it back by 2019.  When they opened the fiscal cannons to put a floor under covid all hell broke loose, and the fire started.  

How any central banker could credibly have stated in 2021 that inflation was likely to be transitory simply beggars belief in my opinion.  I believe it is strongly suggestive of a decision making culture that for decades had been built to sponsor risk seeking and then make it whole again when it became excessive through any policy means available while couching those responses very carefully to appear as though they were mandate driven.  I am here to tell central bankers that ponzi schemes at a macro level are not economic growth.  They are ponzi schemes and they end horribly, and the longer you maintain them with extreme policy the worse the conflagration in the end.  It is how Depressions happen.

It was not mandate driven to keep rates too low for too long.  In the author's humble opinion anybody who believes that the zero interest rate is ever a sane policy decision has no place anywhere near policy decisions.  Sometimes over-leveraged risk seekers have to lose, even (and especially) if they are baby boomers.  The umpire made awful decisions for 30 years and the game is a write off.

Actually, there is a pretty fair argument to be made that the unpire was a bought decision maker, and the mess we are all in represents the simple fact of a baby boomer generational control premium in politics and the greatest achilles heel of democratic capitalism - it is a popularity contest in the end.  There is no room for a popularity contest in national growth policy.  There simply is not.  Too many standards of living depend on it.

Let's get into the details.  Firstly, the real reasons central bankers do everything they do is to stimulate the commercial banking system as hard as they can for as long as they can and then put out the fire as it starts to stop the commercial banking system blowing up.  Do not delude yourself about mandates.  For 30 years there is a clear history of market save followed by systemic save followed by market save.  Policy mandates are like inflations expectations.  It is the language of PR and media management.  They fight inflation when it spikes because it is death to the banking system in the medium term.  They fight market collapses when they happen for the same reason.  The central bank is exactly that - the central bank.  People should read institutional names more carefully and press releases with a serious grain of salt and a serious suspicion of false intellectualism.  No capable intellectual i know is very interested in jobs involving press conferences much.

Inflation is death to the banking system because it destroys the real value of capital.  If you have inflation at 10% for a decade then the same business startup must borrow more than twice as much money for the same real business structure at the end of the decade as it did at the beginning.  If the bank has been charging 5% interest on the loan and booking that as revenue, it's capital base in real terms has halved.  It needs to double its capital base to support the same level of real economic activity.  Now, it is all a little more nuanced of course but that is the plain guts of the argument - and it is a most compelling argument.  Inflationary cycles lead to a need for impossibly major bank recapitalisations, far worse than serious market crashes in either equity or credit markets.  Think that over, reader...

Inflation is death to consumers because their wages are not inflation indexed, and they are particularly exposed to the volatile components of inflation that central bankers prefer to ignore, food and energy.  Central bankers do not like any series that suggests inflation is higher rather than lower.  Decades of very careful media management has been devoted to making our inflation indexes nonsense to this end, to support policy that is too low and too loose, to support risk seeking and speculation, a ponzi scheme re-named growth.

Inflation is death to businesses because in general they cannot effectively predict it, plan for it, or pass it through.  Most real economic activity does not pass through inflation perfectly.  It erodes their capital balance sheets too but not as destructively in general as it does those of banks.  The repositories of capital for lending take the greatest hit.  Real allocated capital does better because it sees equity returns, whereas banks as warehouses of debt capital only recieve fixed debt interest returns.

So high inflation in the medium term is death to banks, and pretty toxic to the firm and household sector too, but the other caveat is that high inflation at high debt levels is double doom and destruction to banks.  

Banks are warehouses of medium to long-term debt.  They intermediate maturity for their customers.  They borrow short and lend to longer time frames.  This classic balance sheet duration risk is wrong way risk in an inflationary environment because interest rates rise in that environment to control inflation.  Of course the more seriously levered the debt warehouse is at the start of the tightening cycle the worse the hangover.  

Well, rates were at zero across the major developed world for a decade.  We are raising off a very convex place on the pricing curve.  We have never been here before.  It is not a good thing.  Raising interest rates from 5% to 10% is a much happier game to be playing on bank balance sheets at the national level than raising interest rates from 0% to 5% basically.  It is the exponential curve in action.  When you fight the exponential curve - you lose badly.

What does this mean?  It means that central banks can forget their 2% inflation targets and deal with quite signfiicant and unpleasant bank recapitalisations in 4-6 years or they can watch a number of very serious asset bubbles they blew up in a frightening ponzi scheme for 30 years blow away like tiny home villages in a hurricane, and lose a few major commercial banks that way.  

There are no good outcomes here.  When you hear central bankers tell you that there is still a narrow path to a recession-less recovery and inflation returning to 2% you should be laughing out loud, in your author's opinion.  When you hear the pundits tell you that housing will sail through the pricing curve adjustment because of tight supply you need to be wearing a gas mask to deal with those particular fumes.  That is nonsense.  Your monthly payment is a formula.  The rest is BS.  Total BS.  Supply is a technical factor but mortgage rate is fundamental.  You cannot pay a mortgage monthly payment with wages you do not earn.  It is the kind of BS that would make a pension broker balk, and those folk do not balk easily at winsome and unwise estimations of the future.

Now you all know why central bankers really fight inflation, then cause it again.  It is all a game in avoiding re-capitalising banks directly.  You will not be fooled by any doughy mouthed talk of mandates.  You should not have been fooled by any doughy mouthed talk of inflation expectations at a horizon for decades.  The whole reason they talk about it is to anchor yours.  You do not want your economic anchors set by central bankers, believe me.

In the next episode we are going to talk about why a ponzi scheme in housing is something you should not get involved in, especially after 25 years of it...