What happens when you mistake a symptom for a disease? Because that’s just what central bankers are doing right now. And their mistake is all that’s keeping stocks afloat.
But that’s not where our tale begins today. Instead, consider what you might found on the banks of the Thames about 200 years ago…
Around 1774, Dr William Hawes and Dr Thomas Cogan formed the creatively named “The Institution for affording immediate Relief to Persons apparently dead, from drowning”. It later became known by the much shorter but ironic name of “Royal Humane Society” and is still sponsored by the Queen today.
Why ironic? Because a tobacco smoke enema was once the recommended cure for drowning and the Humane Society placed… certain inhumane devices… at regular intervals along the Thames, just in case.
Economic science is still very much in the tobacco smoke enema stage. Which is ironic given that’s where it first began too, with Richard Cantillon’s 1755 book on how central bank fiddling creates asset price bubbles where they don’t belong. We haven’t come very far in the nearly 300 years since.
Or, at least, we’ve come full circle. Central bankers are still busy applying tobacco smoke enemas to financial markets in order to prop them up and keep the machine of finance ticking over. Why? To finance governments – what the South Sea and Mississippi bubbles were all about back when they helped Cantillon form his theories about how such bubbles are created and what their effects are.
Without liquid financial markets, central bankers would have to finance government deficits directly, which would be as embarrassing as it is inflationary, or governments would have to balance their budget with taxes. How quaint a notion!
How are central bankers keeping markets afloat? The new method of insertion involves the so-called Jackson Hole – a meeting of central bankers in what just happens to be the wealthiest county in the United States of America. In Wyoming, of all places…
This year, central bankers from around the world declined to attend the meeting because of Covid and it was held virtually.
Wait, what? Is Covid transmissible by Zoom call now?
But how important is Jackson Hole really? Well, it gives us an idea of what the central bankers are thinking. And that happens to be extraordinarily important to stocks in an age of bubbles.
A 2013 study by two Federal Reserve economists concluded that the days on which we get US monetary policy decisions are responsible for 80% of the US market’s returns since 1994:
In the past few decades stocks in the U.S. and several other major economies have experienced large excess returns in anticipation of U.S. monetary policy decisions made at scheduled policy meetings. We refer to this phenomenon as the pre-FOMC announcement drift…
Since 1994 about 80% of realized excess stock returns in the U.S. have been earned in the 24 hours before scheduled monetary policy announcements. …. The S&P500 index has on average increased 49 basis points in the 24 hours before scheduled FOMC [Federal Open Market Committee] announcements. These returns do not revert in subsequent trading days and are orders of magnitude larger than those outside the 24-hour pre-FOMC window. The statistical significance of the pre-FOMC return is very high.
The investment firm GMO had a similar analysis a few years later:
All we did here was to remove the days on which the FOMC met; nothing more, nothing less. This means that we removed around 18 days a year in the 1960s, 14 days a year in the 1970s, and 8 days a year from 1981 onwards. During the period 1964 to 1983 there was absolutely no effect from removing these days. But, from 1985 onwards, removing fewer days began to have a major and increasing impact on the market. In fact, FOMC days account for 25% of the total real returns we have witnessed since 1984!
The idea is that the Federal Reserve’s and other central banks’ money printing – announcements of money printing – are why markets have actually gone up.
Of course, we’ve very much back in a world of central bank intervention driving asset markets again today. So, when central bankers meet up, virtually or not, and discuss future monetary policy – tobacco smoke enemas for stocks – it pays to pay attention, literally.
But here’s the real story you need to be aware of. The one that exposes why tobacco smoke enemas don’t actually work. You see, central bankers have confused the symptom with the disease.
The symptom they focus on is of course inflation. At least, that’s the one symptom that they’re supposed to focus on. But, just for today, let’s assume they’re honest and stupid, not nefarious and captured by their employers, the politicians.
Inflation is defined by central banks as rising prices. Certain prices, that is.
The problem with this is fairly simple. Prices rise and fall for all sorts of reasons every day. How can central bankers distinguish between rising prices caused by supply and demand, versus rising prices caused by the value of money falling?
They can’t, and they don’t even try to.
Oil is a good example. If the price of oil spikes for some geopolitical reason, this is very inflationary for prices overall because the price of oil is factored into just about everything.
But is it a good idea to raise interest rates when the price of oil is spiking, which causes other prices to rise?
I think it’s a terrible idea, because this isn’t inflation, it’s cost pressures and supply and demand which are moving prices, not the falling value of money. Raising interest rates to respond to such “inflation” only makes things worse.
The contrary example is China. If China emerges on to the world’s trading stage and this causes downward pressure on consumer prices for decades as cheap labour and globalisation makes it cheaper to produce consumer goods, central bankers see this as a deflationary problem, and not a good thing for consumers.
Now, to be clear, in that scenario, what has happened is a drop in the cost of manufacturing and transport. This is great news for consumers, which is all of us.
Of course, it’s bad news for competitors of China, but that’s another story which will feature aplenty in Fortune & Freedom, because it may be about to reverse. But, for today, focus on how the central bankers mistake the benefits of China’s return to world trade as a threat to their inflation mandate of 2%.
To central bankers, if we get better at producing something and this allows the price to fall, which improves your standard of living, that is a bad thing. It is a bad thing when your paycheque buys you more stuff if that improvement comes about via cheaper prices. Because deflation is a bad thing, full stop.
Of course, if the reason for prices falling were a crash in the banking system, that really would be a bad thing. Prices would fall as the economy goes into recession.
But the example of cheaper manufacturing is not such a scenario. And the key to understand is that central bankers can’t and don’t try to tell the difference. They just measure price level, not why the change is occurring.
Why does this matter? Because it leads to tobacco smoke enemas for anyone taking a peaceful nap on the side of the Thames. A deeply unpleasant experience for any “Persons apparently dead, from drowning” (my emphasis added). Of course, such people do appear to be immediately cured from their apparent death from drowning when you try and shove a… and you blow tobacco smoke into the…
You get the idea, right? Just because stocks jump up on QE, it doesn’t mean that it’s a good idea to do it.
Let’s return to the beginning of our tale. Central bankers have kept interest rates low for an incredibly long time as inflation remained subdued because of forces which kept prices low. Things like Chinese manufacturing, globalisation and technology. They thought they were fighting off deflation.
But prices were falling because of supply, demand and cost changes, not the unstable value of money. It was a misdiagnosis. Not that the over-enthusiastic central bankers cared.
The side effects of this medication are the bubbles we saw. The tech bubble, housing bubble and the government bond bubble. An era of propping up asset prices alongside consumer prices – which should’ve been falling. But all of those asset price bubbles popped, leaving destruction in their wake.
Tomorrow, we look into a simple question: what if the era of tobacco smoke enemas has come to an end, as it eventually did in the medical profession, as far as I know? What would it mean for asset prices if the support they’ve had during the decades of low inflation is withdrawn by central bankers?
The data deluge I have prepared for you tomorrow suggests that that may have happened. Inflation may be back, requiring tighter monetary policy which undermines the asset price bubbles that we’ve seen for so long and that we are used to.
Nick Hubble
Editor, Fortune & Freedom
