It never ceases to amaze me how many investors, including professional ones, accept central bank policies as a fait accompli and without any value judgement. Central bank analysis rarely goes beyond predicting the timing of the next interest rate step and the total number of interest rate steps that will be implemented over a given period.
Almost never does it discuss the ‹meaningfulness› of the policy objectives or the tricks central banks can all play to achieve those objectives. This is, if you have been closely involved in financial markets since the Great Financial Crisis, downright strange.
Price stability
Take the Bank of Japan. Which, like most other central banks on the planet, aims for price stability. For the Bank of Japan, price stability means a year-on-year change in the Consumer Price Index, read inflation, of 2 percent.
And since just about every (major) central bank uses that definition of price stability, there really isn’t a rooster crowing about this. But why do prices always have to rise 2 per cent? Why is the objective of central banks formulated in such a way that our money must always, but always, become worth less?
The so-called logic behind this is that inflation is the ‹lubricant› of our economy. Oh yes, I don’t think my spending pattern will change if prices always stay the same. Every day I get to hear the ‹magic› text ‹daddy I’m hungry› dozens of times. That bigger (electric!) car to transport my kids to dance class, hockey and football has to come, after long resistance. And I also prefer not to wait for holes to appear in my clothes before I go into town.
You could even go a step further. Our economies, micro and macro, are increasingly digital. They float on technology. And what is the most defining characteristic of technology? That it is rapidly and structurally getting cheaper. From this point of view, deflation should be the ‹base case›. But every central banker spontaneously gets nightmares when he or she thinks about that.
There is obviously a reason I mention the Bank of Japan as an example. After all, that central bank is never going to succeed in structurally achieving 2 percent inflation. For one thing, because central banks have much less influence than they think they do. But in Japan’s case also because the economy simply won’t allow 2 percent inflation. Potential GDP growth falls below 0 percent within the next 10 years. Japan is going to shrink, just as its labour force is already doing.
The claim that Japan cannot manage 2 percent inflation is not an assumption, but a fact. Below is CPI inflation - the definition of price stability thus used by the Bank of Japan - over the past almost 25 years. On average, price growth has been a paltry 0.3 percent, and those brief upturns before 2020 were flattered by a number of VAT increases, which of course ran out the following year. The only way Japan gets 2 percent inflation on the boards is if the yen pops down much harder. But a weak currency is not exactly a winner in a geopolitical trade game.
Secret agenda
Why is the Bank of Japan so stubbornly sticking to that 2 percent inflation target? And why is no one else asking this question? Don’t they want to hear the answer? I do have an idea. Japan is furthest along the (irreversible?) path of debt-driven economics. Because it has the lowest potential growth, it needs the most amount of debt to keep that growth artificially alive.
In a debt-driven economy, central bankers are the ultimate guardians of the system. And how do you keep debt under control as a central banker? Right, low interest rates and higher inflation. In case you are still wondering why Japanese interest rates are only 1 percent despite that mega-debt, you have your answer right here.
So sticking to a totally unrealistic inflation target is another handy trick. And since everything is permitted in the land of central banker to achieve that target, you get to see a lot of fireworks. Who would have thought 20 years ago that central banks would punish us with negative interest rates? And is it a coincidence that Japan reinvented ‹yield curve control› after the Americans did it during a war?
Investors would do well to ask further questions. What exactly are the motivations behind inflation targets and the policies put in place to achieve them? Why does not a single journalist at the Powell press conference ever ask how he views the fact that his central bank had massive US government bonds on its balance sheet while inflation was skyrocketing?
Anyway, should you be on holiday, something for the agenda when everyone from your team is back at their desks neatly (at home). In case you can’t wait, you can also ask the questions to me.
Jeroen Blokland analyses eye-catching, topical charts on financial markets and macroeconomics in his newsletter The Market Routine. He also manages his own multi-asset fund. Previously, Blokland was head of multi-asset at Robeco.