One of the more disturbing meta-trends in markets these days is the direction the evolution of central banking seems to be taking.
I have written before (and pointed to others, including within the Fed, who have written before ) about the disturbing lack of attention being paid in the discussion and execution of monetary policy to anything that remotely resembles money. Whether we have to be concerned about money growth in the short- and medium-terms, ultimately, will depend on what happens to the velocity of money, and on how rapidly the central bank responds to any increase in money velocity. But there are trends that could be much more deleterious in the long run as the fundamental nature of central banking seems to be changing.
Today the Bank of England released its Quarterly Inflation Report, in which it introduced an “Evans Rule” construction to guide its monetary policy looking forward. Specifically, the BoE pledged not to reduce asset purchases until unemployment dropped below 7% (although Mark Carney in the news conference verbally confused reducing asset purchases with raising interest rates), unless:
“in the MPC’s view, CPI inflation 18 to 24 months ahead is more likely than not to be below 2.5 percent; secondly, if medium-term inflation expectations remain sufficiently well anchored; and, thirdly, the Financial Policy Committee has not judged the stance of monetary policy — has not judged — pardon me — the Financial Policy Committee has not judged that the stance of monetary policy poses a significant threat to financial stability, a threat that cannot otherwise be contained through the considerable supervisory and regulatory policy tools of various authorities.”
This is quite considerably parallel to the FOMC’s own rule, and seems to be the “current thinking” among central bankers. But in this particular case, the emperor’s nakedness is revealed: not only is inflation in the UK already above the 2.5% target, at 2.9% and rising from the lows around 2.2% last year, but the inflation swaps market doesn’t contemplate any decline in that inflation rate for the full length of the curve. Not that the swaps market is necessarily correct…but I’ll take a market-based forecast over an economist consensus, any day of the week.
So, for all intents and purposes, while the BOE is saying that inflation remains their primary target, Carney is saying (as my friend Andy the fxpoet put it today) “…the BOE’s inflation mandate was really quite flexible. In other words, he doesn’t really care about it at all.”
Along with this, consider that the candidates which have so far been mooted as possible replacements for Bernanke at the US Fed are all various shades of dovish.
Here, then, we see the possible long-term repercussions of the 2008 crisis and the weak recovery on the whole landscape of monetary policy going forward for many years. In some sense, perhaps it is a natural response to the failure or monetary policy to “get growth going,” although as I never tire of pointing out monetary policy isn’t supposed to have a big impact on growth. So, the institutions are evolving to be even more dovish.
At one time, I thought it would happen the other way. I figured that, since the ultimate outcome of this monetary policy experiment is clearly going to be higher inflation, the reaction would be to put hawkish central bankers in charge for many years. But as it turns out, the economic cycle actually exceeded the institutional cycle in duration. In other words, institutions usually evolve so slowly that they tend not to evolve in ways that truly hurt them, since the implications of their evolution become apparent more quickly than further evolution can kick in and compound the problem. In this case, the monetary response to the crisis, and the aftermath, has taken so long – it’s only half over, since rates have gone down but not returned to normal – that the institutions in question are evolving with only half of the episode complete. That’s pretty unusual!
And it is pretty bad. Not only are central banks evolving to become ever-more-dovish right exactly at the time when they need to be guarding ever-more-diligently against rising inflation as rates and hence money velocity turn higher, but they are also becoming less independent at the same time. A reader sent me a link to an article by Philadelphia Fed President Plosser, who points out that the boundaries between fiscal and monetary policy are becoming dangerously blurred. It is somewhat comforting that some policymakers perceive this and are on guard against it, but so far they seem ineffectual in preventing the disturbing evolution of central banking.
 Consider reading almost anything by Daniel L. Thornton at the St. Louis Fed; his perspective is summed up in the opening sentence of his 2012 paper entitled “Why Money Matters, and Interest Rates Don’t,” which reads “Today ‘monetary policy’ should be more aptly named ‘interest rate policy’ because policymakers pay virtually no attention to money.”
A quick summary of where we are in the “global currency war:”
For several years now, global central banks have been engaging quietly in this war. Each central bank has been implicitly playing “beggar-thy-neighbor” by making its currency relatively plentiful, and therefore relatively cheaper, than its neighbors. In one case, that of Switzerland, the currency issue became explicit rather than implicit, though not to weaken its currency but rather to stop it from strengthening without bound (see Chart, source Bloomberg). It is instructive that, in order to accomplish this end, the SNB had to pledge to print unlimited quantities of Swiss Francs to sell – essentially saying that if it can’t beat ‘em, it would have to join ‘em.
Now, in January some well-known asset managers muttered the ‘currency war’ phrase, and Japan’s Economic Minister Akira Amari suggested that the Yen could fall 10% (and Japanese officials have implied that they are looking for such a move to help end deflation). Since then, both the G20 and the G7 have discussed whether countries ought to be engaging in currency adjustment as a means of confronting macroeconomic challenges. Searches for the term “currency war” on Google (see chart, source Google) have risen appreciably. But again, this isn’t really new; what’s new is that people are actually talking about it.
Earlier this month Adair Turner, chairman of the Financial Services Authority talked about “permanent monetary easing” and said that central bankers “may need to be a little bit more relaxed about the creation” of money. By permanent, he means that the central bank would print money with the express intention that the printing would never be reversed. Ignoring history, Lord Turner said “the potential benefits of paper money creation [to stimulate the economy] should not be ignored.” Today, the Bank of England released its quarterly forecasts, showing policymaker expectations that inflation will stay higher than the Bank’s target for longer than expected, and growth will be weaker than expected. Even less surprising, given talk about “permanent” easing, is that 10-year UK inflation swaps are now back above 3.40% (see chart, source Bloomberg). The first 30bps of this jump was due to the decision by the ONS to maintain the current definition of RPI for existing contracts (I mentioned this here), but some amount of it is probably due to the currency wars talk.
It bears noting too that the 10-year US inflation swap is within a handful of basis points of its post-Lehman highs.
The UK inflation market has been around longer than other inflation markets. Index-linked Gilts date back to the early 1980s. So I wonder whether we shouldn’t be a bit more curious about how much of the rise in UK inflation expectations actually reflect a rise in global inflation expectations due to the currency wars that are (and have been) underway.
Because to some extent, the question of “who will win” the currency war is difficult to discern, and to some extent the question is moot. Like in the movie “WarGames,” the only thing that has been certain since the currency war started a couple of years ago is that there will be a lot of scorched earth. The only real “winners” are debtors, relative to lenders.
Who will win? To change the analogy: if you’re in a bay surrounded by people in boats who are pumping water in so that they can see who can sink his boat the fastest, the winner is the one who is wearing a life vest. All the others are just some varying grade of loser. Don’t be the last one to grab a life vest.