The Powell Put is dead

As ever, I hope this letter finds you all well and healthy.

One thing I’m often told is that you learn a lot about people during the good times, but that you learn most about them during the bad.

Some might have hoped that the extraordinary excess created by central banks since the last crisis, now so widely criticised, might ignite some introspection within the hallowed walls of the Federal Reserve, or the glass tower of the European Central Bank in Frankfurt.

It’s a failure to realise any second-wave effects of their actions. The behavioural economists would be devastated, as their work is based on understanding the incentives and nudges that encourage humans to behave in a certain way.

For example, if it’s easier for management to get paid by buying back shares to boost their earnings per share figures, then you don’t get many prizes for guessing what’s happened in the last decade.

One chart from Ruffer LLP has shown that US executives’ pay, all incentives included (bonuses, shares, etc), has gone up 974% relative to average US wages, from 1978 to 2018. You might notice that that’s pretty much the exact period of steady declines in interest rates… God bless the central banks eh….

As borrowing gets cheaper, companies do more but has it done anyone any good? Executives and shareholders yes, 95% of the population no.

A quick caveat, I am actually not wholly opposed to Modern Monetary Theory (MMT) and am not at all opposed to the measures enacted by the UK government to spend, spend, spend in this crisis. I am glad to see it going directly to business and jobs, as will the US package of $2tn (that’s what inflation looks like by the way – they were only asking for $750bn halfway through last week!).

Having said that, the Fed and the European Central Bank have really deeply disappointed me.

Let me tell you why.

It’s like when someone gets caught out, but just denies it or gets away with it. It’s so frustrating! Like that person who always cut corners in class then asked for your answers, or who ate all their snacks in the first hour of the road trip and then asks for some of yours.

For ten years, the world’s central banks have been inflating markets out of proportion. And when their bubble has been pricked, they haven’t had a rethink, they have doubled down.

They are throwing good money after bad. Making the problem worse.

Did they ever stop to ask themselves why the stockmarket crash has been so extreme, so fast, so unprecedented?

It’s likely because the conditions preceding it were so overvalued and inflated that they were unprecedented in their own right.

All thanks to quantitative easing (QE) and low rates. Rates which were supposed to rise within months of their emergency lows.

I recently read a piece from 2009 in which a fund manager stated coolly that one thing investors needed to prepare for was rising interest rates, because there was no way rates could stay at these crazy emergency lows for longer than a year.

I don’t judge him for that by the way, at the time it would’ve seemed implausible and mad. In investment you must always judge the decision, not the outcome.

Few people understand the way in which crises allow for temporary crisis measures, which the government then gently decides to hold on to.

Now I’m hoping that extra police rights, curfews, limits on public gatherings and the rest don’t become permanent, but now we know the government has that power, and it’s not a soothing prospect.

But the unlimited power of those in power to print money and give it to people through gifts, loans or asset purchases is new, and is likelier to see regular use by our governments.

Many people are now saying that the last round of QE proved that inflation isn’t a risk. Just as that chap I read couldn’t fathom low rates enduring for longer than six months.

They say that the current stimulus is only replacing wealth that has already been destroyed by the virus and government responses, and that’s true to an extent.

However, there has been a fundamental shift in the thought underlying the way our economies work. The concept of unlimited fiscal and monetary power is new.

You will have read about MMT before I’m sure. It’s a new view of how economies can work, which says that governments can print and spend as much as they like, and that it’s not taxes and revenues which limit government spending, but inflation.

It’s interesting, and though I don’t totally buy into it, nor do I wholly reject some of its merits in challenging some current beliefs, which are also imperfect.

But it has been gaining favour in certain academic and political circles for a while now.

The key point is that revenues and tax aren’t the limit on government spending, inflation is.

It means you can pay the wages of every hospitality worker in the country, keep liquidity high in the financial system, and while you’re at it, cover that gaping pension shortfall that we face as a nation, as long as inflation doesn’t exceed limits.

What is inflation then? It’s a measure of the changes in prices of goods in a country.

The trouble is, the measures are arbitrary and change according to the whims of the government. The UK changed the definition of inflation from Retail Price Index (RPI) to Consumer Price Index (CPI), which is typically almost a per cent lower.

The RPI excluded some households, such as students or the highest earners, while the CPI excludes mortgage payments, so changes in interest rates affect the RPI but not the CPI.

But crucially, neither includes financial assets or house prices. Both of which have surged since 2008.

The two key points here are that inflation doesn’t cover everything so it isn’t a great measure for most people, and that it can be changed according to what the government wants it to be anyway.

For example, in the US inflation has been minimal, but try telling that to people trying to pay for their healthcare insurance.

And it differs from region to region too. London house prices are double what they were in 2007, relative to wages, but in some parts of England they haven’t even surpassed their peak.

So MMT does struggle when it says inflation is the only limit on spending. While it makes some sense to throw as much money as you can at the economy before prices start getting away from you, in a way it’s not perfect because its limit is arbitrary, incomplete and susceptible to politically motivated meddling. Not a good combination, if you ask me.

And don’t forget Goodhart’s Law – that once a measure becomes a target, it ceases to become a good measure. Why? Because targeting something makes you behave differently, changing the reality upon which the previous measure was based, and creating distortions.

Be careful what you wish for

When the recent election came around, a key factor hindering Jeremy Corbyn was that the decade in which he learned his economic views is seen as pretty much the worst decade in living memory for most baby boomers.

Inflation was rampant, strikes couldn’t make wage-payers keep up, bins weren’t collected, lights went out regularly… and it all ended in misery in the 1974 crash. House prices collapsed and many lives were ruined.

The fear of inflation is well-founded and should be remembered now more than ever, because it is threating us once more.

Sure, a bit might be good. But do we really need it? Everyone criticises Japan for being deflationary, but there’s a lot to like about Japan – very little poverty, crime, and destitution, next to no homelessness, and pretty ubiquitous living standards.

Sure, its stockmarket hasn’t beaten its highs of 30 years ago, but who cares? People live well, and life has certainly improved since then because of technology, supply chains, globalisation, and the rest of it.

Yes, it has its drawbacks too, but it’s not as bad as rampant inflation I would suggest.

If you want an example of what inflation can do, try this (mental exercises in bold):

2% inflation results in 100% inflation after 35 years. That’s a halving in the value of money – ie, it buys half as much stuff. To help you picture this, take your bank balance today and cut it in half. That’s what inflation does in 35 years at 2%.

What about 4%, a figure being thrown around as a potential new target for central banks to make up, miss and mess around with?

Well 4% compounds to halve your savings in just 18 years.

And at 10% it takes just over seven years to cut your lifelong savings in half.

And in just over 24 years, 10% annual inflation compounds to nearly totally destruct your savings. Accumulated inflation is 1,000% at this point, and to illustrate what that does to your savings, take your current bank balance and move the decimal point one number to the left.

Not a fun exercise.

But it is the only way out of the hole we have now dug for ourselves.

Debt has grown and grown because central banks supported the moral hazard after the last crisis, telling corporations that high levels of debt would lead to bailouts, not bankruptcies.

When faced with unsustainable debt levels, governments face only a few options. Bankruptcy, a debt jubilee, or inflation.

Which do you think they will choose? Perhaps we have already seen their answer.

Rishi Sunak’s unlimited powers have two-fold potential. Firstly, to genuinely help people and businesses get through the current calamity, which is a good thing.

But it also paves the way to inflate away the government’s debts. Which is a good thing too… if you’re a government.

When the monarchs of old used to borrow money to fund wars, they could never pay it back with the spoils. It was a classic case of lessons not learned, runaway greed and a lust for war.

Every time, to pay off their new debts they would call in all the currency in the form of coins, literally melt it down, add in more impurities to lower the gold, silver or copper content, and then reissue it in a process known as debasement.

What we are seeing now is the direct descendent of the debasements of old.

Can’t pay back that million quid? Debase the currency and a million quid is no longer 40 ounces of gold, but 20. As Borat would say, great success!

And that is what is happening now.

As the financial system threatens to melt down once again, the government is using this crisis as a cover to debase the currency so it can repay its debts.

And it’s your savings that will suffer. Your bank accounts, your retirements, college funds and the rest of it.

The low interest rates environment has done more harm than good, and in my opinion it should and will end soon (deliberately ambiguous).

So rising inflation, interest rates following close behind… that’s not such good news for stocks, bonds and the rest in the coming years, or even decades.

The incredible returns we have seen since the 1970s are testament to the usefulness of falling rates for valuing stocks, so watch out because the reverse will be true for the decades to come.

And if stocks and bonds are no longer the best things to own in this new inflationary era, what is?

On Monday, I mentioned that a pal of mine, Nick Hubble, has spent years researching financial crises, central banking failures and the plumbing of the financial system. He is a terrifically intelligent thinker and strategist when it comes to these larger, macro questions.

So, I asked him if he might have anything of use to any of my readers, and he told me he did.

If you follow , you can hear from him directly, and he has put together a crisis care package of six assets to own to protect your wealth in times like these. These assets should perform far better than any stockmarket in a crash or panic.

And not just that, they are perfectly set up for the steady, grinding destruction of the value of our savings and investments as the new inflationary regime gets into first gear.

They’re not just protections against the current panic, they’re also long-term plays for the scary scenario which now confronts us.

So again, if you want to hear from the man himself, from whom I’ve learned a huge amount over the years,

I hope you are well and enjoying this respite from the calamitous market collapse of the last few weeks. I hope it continues, but I want never gets…

Very best wishes, and I’ll see you again on Friday.

Kit Winder
Investment Research Analyst, Southbank Investment Research

1 Comment
  1. […] structural issues include inflation. I spoke about this on Wednesday (you can find the article here), and there is a strong case for saying that once this obviously deflationary year is over, the […]

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