Governments are about
to lose control of the markets
The
low interest rate honeymoon is coming to an end, and we
can now expect rates to rise and continue to rise for
the foreseeable future. For Western economies and their
banking systems it is the worst possible time for this
to happen. The reason interest rates will go up is
because inflation, not deflation, now presents the
greatest danger and a policy response is required.
Agricultural commodity prices have been rising for some
time, and the central banks have dismissed them as being
due to special factors and too small a part of the CPI
to worry about. To this inconvenience can now be added
the political revolutions in the Middle East and their
effect on energy prices. It is perhaps this development
that forced Jean-Claude Trichet to break ranks last week
and admit that the ECB will have to consider an interest
rate rise.
There is no such admission from Mr Bernanke and Mr King,
the latter still denying that an official UK inflation
rate of over 4% requires remedial action. And this high
inflation rate was recorded before the current jump in
energy costs. All three central bankers have been
effectively caught on the hop by events. They have been
ignoring inflation while wrestling with two immediate
problems: financing government budget deficits and
keeping the banking system alive. For these reasons the
Fed and the BoE have been simply printing money by
buying government debt. What made this strategy
attractive is that it lowered the cost of government
borrowing below that demanded by the free market, making
government finances appear far better than they would be
without this intervention, and at the same time it gives
valuable breathing-space to the banking system.
Consequently, there is money in circulation that will
have to be neutralised if inflation is to be controlled.
It will require the central banks to sell back into the
markets much of the government stock they have
accumulated, at the same time as government borrowing
continues at its high pace. This will force governments
to bid up against their own central banks in the market
for private sector savings. The increase in interest
rates along the yield curve would therefore be sudden
and brutal, and theoretically only stop when enough
consumption is switched into savings, attracted by the
high rates.
For
this to happen when economies are fragile is the last
thing the central banks need. Any hope of economic
recovery will be quickly replaced by expectations of a
slump, leading to deterioration in government finances
everywhere, as tax revenue estimates are adjusted
sharply downwards and welfare commitments sharply
upwards. Add to that increases in the cost of government
borrowing from higher interest rates, and the sudden
collapse in government finances becomes truly alarming.
The dramatic moves in the prices of precious metals are,
perhaps, an early warning of this escalating risk.
The
prospects for precious metals will ultimately depend on
the central banks determination to control inflation. If
only it was so simple; but a higher interest rate
environment will break the banks, which are full of
dodgy loans dating from credit-crunch days. So what does
a central banker do? Does he squeeze inflation out of
the system, while governments slash their spending, or
does he find another way of rigging the markets, while
governments dither over their deteriorating finances?
Paul Volcker faced up to the problem and picked the
former course thirty years ago, but this time the levels
of private and public sector debt are a whole magnitude
larger and government spending is a far greater problem.
This time, embarking on austerity and interest rate
plans sufficient to control inflation is simply too
painful to contemplate in social democracies. The
markets are beginning to understand this, having now
been kicked awake by escalating energy prices.
History never repeats itself precisely, but there are
similarities to late 1973, when inflation was on the
rise and the Arab oil-producing nations imposed an oil
embargo on Western nations, leading to considerably
higher energy prices. This gives us perhaps a basis for
divining today’s outcome, but there were notable
differences.
US
Inflation, on a comparable basis, is now running at
about 5%[i]
compared with 6% then, but interest rates are now close
to zero compared with 7% in October 1973. An
inflationary kick from higher oil prices could therefore
lead to a much greater interest rate increase today.
Government finances were far stronger then, reflecting
economic growth, compared with the serious and
deteriorating situation now. So rather than higher oil
prices occurring at the top of the economic cycle, today
it is happening when the world’s developed economies are
struggling to recover.
The
pick-up in inflation today is therefore more directly a
function of monetary developments than excess demand.
Arguably, this makes it more considerably serious than
that faced in October 1973, which was easier to
diagnose. It is a direct consequence of the monetary
expansion that is the bedrock of economic policy. This
is not welcomed by the establishment, which seems to
think inflation can only occur as a result of excess
demand. That is perhaps why the Mervyn Kings and Ben
Bernankes of this world turn a blind eye to inflationary
pressures, because so far as they are concerned it
should not be happening until later in the cycle.
This unfortunate result of current monetary policy gives
them an uncomfortable dilemma, because the consequences
of stopping or even slowing the printing presses are too
ghastly for them to contemplate. The truth is that there
are not enough lenders, other than the central banks
themselves, to finance government deficits at anything
like current interest rates. To stop printing puts
government finances in deep crisis and runs counter to
cherished Keynesian and monetary theories, so it is hard
to see how central bankers will take the initiative to
jack up interest rates and bring inflation under
control.
This phase of the inflation crisis has been brewing
since the Lehman bankruptcy, when the Fed first
dramatically expanded its balance sheet to rescue the
American banking system. The policy since then has been
to muddle along, printing more money to cover deficits
and to get the economy recovering. But the crisis in the
Middle East is putting an end to that approach and
control of the markets is therefore shifting away from
the authorities. The markets will raise interest rates
against inflating governments whether they like it or
not, and their currencies will suffer if central banks
are slow to respond. At long last, markets will make
governments face the reality they have been so keen to
avoid.
The
effect on asset prices will be dramatic, and share and
bond markets, currently reflecting zero interest rates,
are likely to be badly hit. Property is similarly
vulnerable, with the end of any pretence that
over-leveraged homeowners can afford their mortgages and
commercial property tenants their rents. Values for
collateral held by the banks against their loan books
will therefore be further undermined, putting into doubt
the banking system’s survival.
This new phase is stagflation, pure and simple. Asset
prices fall, while the prices of goods rise. It is an
outcome that has been obvious to some of us since the
printing-presses were first cranked up after the
credit-crunch. It will now become obvious to the wider
public, because the authorities are finally losing
control of the markets.
7 March 2011
[i]
See
www.Shadowstats.com, which removes most of
the “adjustments” to the CPI that have been made
over the last thirty years.
