31Aug 2016

Maximilien Macmillan,
Investment Manager,
Fixed Income - EMEA

Don't blame the central bank

The building blocks of the world’s economies are out of sync. Ineffective public policy is weighing on demand, while technological evolution is in the midst of generating far greater supply. The progression of technological advances cannot (and should not) be stifled so how can we solve this imbalance? The most obvious way would appear to be to address the relationship between fiscal and monetary policy causing weak demand.

Out of sync

Supply and demand being out of balance is an odd concept. Supply is always equal to demand in a transactional sense; all that is sold is bought. But in some circumstances weakness in demand, the absence of attractive prospective investment returns and the lack of traction gained by falling costs of funding all mean that growth remains below the level of which the economy is capable.

Anemic rates of global inflation are testimony to the fact that we are operating below potential, with demand falling short of supply capacity. Partly to blame is the fact that supply capacity itself may be improving due, in part, to developments in artificial intelligence and robotics, and more important in this context is the hangover from the Global Financial Crisis, knocking a hole in the edifice that has not been fully repaired.

So, supply and demand can become out of sync and economic crises do happen. As Keynes famously remarked, at times money is hoarded and not spent on products. Activity falls, and the public sector should intervene to prop up demand. However, the duality currently splitting the public sector between fiscal and monetary policy is giving rise to economic problems that needn’t exist.


Monetary policy and fiscal policy are distinct functions, but that does not mean a central bank needs to be an entirely independent institution.

There were good reasons why this split was first introduced. Politicians were seen as unworthy custodians of our fiat currencies liable to over-stimulate and inflate away the worth of money in pursuit of re-election through populist policies. This concern still stands but absolute central bank independence needn’t be the only way to protect our currencies from debasement and bring rigour to the management of economic demand. In fact, the spurious duality in the public sector is giving rise to public policy confusion.

The schism in public policy has meant governments have been unable to monetise debt (spend money by printing it), resulting in soaring debt to GDP levels seen to prevent further stimulus from occurring. Central banks, unable to inject money into the economy directly have sought to stimulate activity indirectly, acting as a ghost in the great economic machine. At the zero lower bound, it has led them to invent an array of unconventional measures of diminishing effectiveness but increasing unintended and distortionary consequences for financial markets.

What’s more, central bank credibility is dwindling as the theory they rely upon is challenged. Allegedly their actions are meant to raise inflation expectations thereby reducing real rates of interest, which in turn stimulates growth and brings about the inflation that validates the expectations.

However, this is not happening. Central bank action has been, as Keynes had warned Roosevelt, “like trying to get fat by buying a larger belt”. In a world lacking in nominal demand, the market correctly refuses to believe that lower real rates are the answer. Expected future inflation fails to rise when central banks ease policy, real rates no longer fall and the economy is not stimulated – a classic liquidity trap.

Confusing matters further, institutions such as the International Monetary Fund seem to oscillate, schizophrenically, between advocating fiscal restraint and stimulus. Central banks in their desperation keep on appealing to government assistance in supporting demand, while governments to the contrary talk of bringing debt levels under control and reigning in excessive spending.

The emphasis in policy discussions keeps shifting from monetary to fiscal and back, leaving observers feeling as though they were attending a tennis game at Roland Garros. Meanwhile, the idea is dawning that the two levers of public policy can no longer operate in isolation. Much talked of public sector use of ‘helicopter money’ is a live example of the increasingly tangled logic of church and state-like separation of monetary and fiscal policy. Something must urgently be done.

The solution may be simple, and merely involve a re-framing of the issue at hand. Public sector policy can be far more effective if construed as the work of a single overarching institution coordinating monetary and fiscal policy appropriately.

In our fiat currency system, the public sector should be able to mop up any nominal demand deficit by printing and spending its own money. Of course, it needs to be limited in the extent to which it uses money printing to avoid excessive stimulus that would debase the currency, and this will require a new institutional framework. But it should not stop us from finding a way out of the current demand deficit impasse.

The upshot for major world economies

In the near future, the disconnect between supply capacity and aggregate demand will remain, continuing to generate anemic inflation and a underlying downward trend in developed market government bond yields, as cash is hoarded.

The normalisation of the US Federal Reserve’s policy will continue to be limited by the threat it represents to the precarious state of the global economy. Being the global reserve currency, the US dollar acts as an unwelcome propagation channel for US monetary policy to countries whose economic needs strongly differ.

As rates increase in the US, others such as China and other emerging markets are pressured to tighten policy in step to avoid excessive currency devaluation. The tightening is particularly damaging in a context in which they have already suffered from outflows caused by the rise in the cost of US dollar funding and the fall in commodity prices that occurred over the past several years.

Not unlike the problem of the Eurozone, emblematic of the pitfalls of a one size fits all central bank rate, the Fed through its actions constantly risks applying too much pressure to a needle already pressed against an inflated balloon.

Yet evading US rates normalisation in the short term is no panacea. It provides temporary support for risk assets and breathing space for emerging markets, but leaves open the question of what happens when the high likelihood of a low probability shock eventuates, or the Fed ends up having to hike strongly to satisfy domestic requirements further down the line.

Conditions may remain supportive and markets relatively stable, but downside risks are looming. In the absence of substantial structural change that reinvigorates growth and enables us to capitalize on the ongoing technological revolution, we should expect cycles of volatility to continue, capping the gains that can be expected for risk assets with already high valuations.

The time has come to question the notion of an isolated and independent central bank seeking to manage demand indirectly only by setting the price of money. We had thought central bank independence was the best way to protect price stability while stimulating the economy appropriately but have learnt that this cannot work in all circumstances. The danger lies in digging in our heels and not acknowledging our mistakes. We must have the sense to see through the constraints of our current mindsets and resulting institutional arrangements, and to improve them. If we do, then the global economy will almost certainly be in a far better place.


Investment Idea

Corporate Bonds

Investment Idea

Equity diversification

Investment Idea