What will be the next market interventions from Central Banks to achieve inflation targets?

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Talked about the inflation targets, interest rates and monetary policy over the past few weeks – Today – go further into looking at a completely controlled economy by Central Banks –

To start – look back to an RBA paper from 1975

– this was where a thing called Goodhart’s law originated – from economist Charles Goodhart –

1. Phrased as “When a measure becomes a target, it ceases to be a good measure.”
   1. Applied in economics – based on the economic idea of rational expectations
   2. Entities who are aware of a system – rewards and punishments – will aim to optimise their actions to achieve their desired results
      1. E.g. employees whose performance in a company is measured by some known quantitative measure (cars sold in a month etc.) will attempt to optimise with respect to that measure regardless of whether or not their behaviour is profit-maximising – Sell all the cars at $100 – looks good for your performance but sends the company bankrupt – now your performance doesn’t matter as you don’t have a job
      2. Example of central planning (top down) policy – similar to socialism where measurement by weight in output leads to massive unusable nails – like the Soviet Union
2. For central banks – also occurs when individuals and investors know the policy decisions and then take actions that that can result in different outcomes on the target
1. Example – signals from banks to lower interest – may increase prices of assets or be a bad sign for the economy = People may invest or start saving = less spending to policy to control inflation results in opposite direction –
2. Individuals adapt – homoecnomicus doesn’t exist – the rational man that economic modelling relies upon
3. Goodhart’s law explains – when a feature of the economy is picked as an indicator of the economy, then it inexorably ceases to function as that indicator because people start to game it – but relies on everyone being rational
   1. Rational – depends on knowing how to act in response – most people don’t except those who know how to
4. Big part of the widening wealth gaps (not income inequality) – I think it is between those in the past 25 years – or at least benefited through rising house prices and markets
3. When the target is set – central banks aim to achieve the inflation rates regardless of consequences – They are set on their path to get back to 2.5% inflation while keeping economic stability –
   1. No secrets when it comes to how central banks are likely to respond – look at the trend – they ever increase their intervention into the economy to control it – all in an effort to hit their precious inflation target – to keep banks (central and commercial) and governments both happy – last Wednesday’s episode: https://financeandfury.com.au/why-do-central-banks-target-2-3-inflation-and-what-are-they-trying-to-accomplish-by-having-it-in-that-range/

1. What will they do to achieve it – requires total control and increased monetary control and intervention into markets – following the trend – but it wont work long term – so more control and intervention is needed – central banks think of themselves as all powerful – to admit they don’t know what they are doing and have at ever step done more damage than good since 1913 – that isn’t what something all powerful would admit to – shows they aren’t all powerful and not needed in their current function
2. While original statement of Goodhart’s law fast saw light when Charles delivered it to a conference in July 1975 to the RBA
   1. General phrase – “When a measure becomes a target, it ceases to be a good measure.” 
   2. But the original formulation was: Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes
   3. has profound implications for the selection of high-level targets in organizations – across both risk and reward.
   4. Jón Danı́elsson quotes the law as “Any statistical relationship will break down when used for policy purposes”
      1. In financial risk modelling – “A risk model breaks down when used for regulatory purposes.”
   5. All metrics of scientific evaluation are bound to be abused – even those of citations in scientific papers – or Wikipedia
3. Where to from here? – what will central banks start doing? – then what will they continue to try and do? 4 steps
   1. Permanent QE – will start to become a way to keep markets dropping – soak out additional supply
   2. Lowering rates and moving towards cashless economy to avoid BOJ situation
   3. Fiscal expansion – Government spending – and redistribution in the form of Helicopter money
   4. Abandon the dollar – IMF SDR – new reserve digital currency
4. GO through one and two now – next Monday go through last 2 stages –

Policy 1: Permanent Quantitative Easing

8. Gone through QE – printing money to buy assets – bonds, ETFs – aim to create inflation through the wealth effect
   1. Since 2009 – Monetary printing failed to inflate away our debts – there is diminishing marginal effectiveness the more is printed
   2. Doesn’t mean that it will likely be discontinued anytime soon –announcement last week that the Fed was resuming Permanent QE OMO after a 5-year hiatus
   3. Aim was to kick-off inflation (via the money multiplier and the velocity of money) – Didn’t work –
      1. What it has done is debase the currency all along – creating inflation in developing countries for food
      2. Has become a race to the bottom between currency debasement and structural global deflationary trends
      3. Japan example – monetary base moved from 60% of US monetary base in 2014 to 100% today – economy two thirds smaller – same money for 1/3rd economy size – BoJ will eventually own most JGBs
         1. Japanese Government will need to issue new bonds just for the purposes of buying out maturing bonds
         2. BoJ already owns approx. 50% of all eligible equity ETFs in Japan – buying $30bn p.a.

9. Hasn’t worked – expansion of monetary policy alone is not enough – There are a few limitations with it:
   1. Failure of the transmission channel – Central Banks gives money to commercial banks – not much is lent to the real economy – burdened by legacy non-performing loans and capital constraints – low-risk high collateral housing markets
      1. Also, in a deflationary economy, demand for loans is anaemic – who wants to borrow to pay more real value back?
      2. Keynes – “you can lead a horse to water but you can’t make him drink” – If there are no real expected returns anywhere in the economy – this dampens new investments by companies (hiring plans, plant & machinery, and related borrowing) – makes for a worse economic situation
   2. QE has capacity issues – QE done through buying bonds or shares – at some point there may not be enough bonds out there
      1. Also – when Central Banks buy bonds – removed from the market which negatively impacts the liquidity of the market itself – same with ETFs
      2. Example: Europe – liquidity on corporate bonds is now dreadful, and where a chunk of bonds now trade at yields to maturity below -40bps – makes them useless for QE purposes

Policy 2: By-product of the increase in money supply

– Negative Interest Rates requiring and Cashless Economy

1. We have seen negative rates across the globe in small economies – Switzerland, Denmark, Sweden – and large ones – Japan, Germany, ECB.
   1. All have different reasons why – ranging from preventing the currency from appreciating, to de-incentivizing cash hoarding for banks while trying to incentivise borrowing – assume negative rates are here to stay in these economics – thanks to the global economy, it puts pressure on other countries to follow suit
2. With negative rates comes the need for a cashless society – a consequence and a necessary complement of QE programs – The banning of cash seems to already be in the works with bits of legislation – currency restriction bill
   1. Not science fiction – 1933 – Executive Order 6102 was issued by Roosevelt – forbid gold hoarding
      1. Hoarding of Gold was blamed for constraining the money supply – safe deposit boxes in the county were seized and searched for Gold
      2. Today – Money supply is somewhat already constrained today by hoarding – substitution of cash in the bank accounts with banknotes under the mattress
      3. Similar issues, similar remedies: a modern version Executive Order may one day be imagined for banning the possession of cash.

3. There are a few reasons for cash to be discontinued and replaced by digital transactions alone.
   1. Banks cannot cover the cost of negative rates forever – start having to charge depositors like Switzerland
      1. Cash hoarding would itself be deflationary and self-defeating to the policy of dropping rates – to have people spend instead of save – also create possibility of bank runs and serial defaults
      2. Only way to avoid that is a cashless economy – central banks will be arguing that better control is exerted on inflation risks down the line through doing this – Central Bank will claim to have more control over the quantity and the velocity of money
4. The first steps come from Capital controls – discontinued production of large bank notes – 500 EUR banknotes, while Larry Summers in the US discusses the case for discontinuing the $100 bills.

Summary 

1. First two steps will be further involvement in financial markets and aiming to hold up housing prices
   1. Central banks entering the QE and asset purchase markets in perpetuity
   2. Rates continue to drop if inflation doesn’t materialise –
2. Aim to take capital controls over physical cash – will get to the point if the economy doesn’t turn around to push rates negative
3. Next steps – next week
   1. Fiscal expansion – Government spending – and redistribution in the form of Helicopter money
   2. Abandon the dollar – IMF SDR – new reserve digital currency

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