In their lifetime, the average baby-boomer has experienced six major market crashes in stocks, bonds or real estate. That’s a lot. Most of these could probably have been avoided had central banks chosen to steer clear of them. That’s why some analysts consider that it is high time for central banks to aim not only for stable consumer prices but also for stable asset prices.
The key mandate of central banks is consumer price stability, and that fight against inflation has increasingly become illusory, believes Jean-Pierre Couture, chief economist and portfolio manager at Hexavest. “Their mandate is completely outdated, he says. Since 1874, yearly inflation has surpassed 10% for only two reasons: wars and oil shocks. Since the oil shocks of 1972, inflation has been extremely tame. Today, central bankers are chasing a ghost. In fact, they have practically no control over inflation. With the fluidity of commerce and the global alternatives that people can call on, it’s a pipe dream.”
In reality, as the present crisis shows, central banks are working overtime to stabilize asset prices (which include stocks, bonds and real estate), mostly bonds. But that mandate is implicit, and not advertised as such. Isn’t that “occult” mandate one-legged? “It certainly is”, agrees Crista Caughlin, a portfolio manager specializing in bonds at Mawer Investment Management. For the last 15 years, central banks have been hopping on their right leg, massively intervening to keep asset prices afloat, but they have forgotten to practice their left-leg hop, hiking rates to prevent asset bubbles from building.
Too Late, Too Fast
The last time central banks tried pushing up rates was from the end of 2015 through 2018. At that moment, the Fed ratcheted rates from a floor of 0.14% in December 2015 up to a peak of 2.4% in January 2019. “But interest rates on corporate debt was quickly becoming prohibitively high, and the Fed was acutely aware of the high level of corporate indebtedness,” recalls Couture. In just 10 months, from July 2019 to May 2020, the Fed brought rates back down to 0.05%.
Couture claims that the Fed increased rates too late. Since 2012, the economy had been picking up vigorously and full employment was becoming a tangible reality; the Fed and the Bank of Canada had every opportunity to correct the excessively low rates they had put in place and which were creating a bubble in corporate debt. But they put it off. When they did get around to it, “corporate over-indebtedness and the massive bond refinancing to come were such that the world outlook rapidly deteriorated following the interest rate increases, claims Couture. Central banks were forced to back off.”
But central banks did not only intervene too late, they also pushed on rates too hard. At that time, an analyst pointed out that going from 0.14% to 2.40% was a 15-factor increase in less than two years, a rate of increase unheard of before. Bloated with debt, corporations simply couldn’t take on the extra load of interest payments.
Big Picture Inflation
Caughlin considers widening the definition of ‘inflation’. “I think that asset price inflation should be a component of the inflation target (of central banks), she says. Inflation is seen only as the consumer price index bucket, but already in the Greenspan years, we were seeing asset price inflation, but we were missing that part.”
Because of their reluctance to kick the asset inflation bucket with their left foot (by increasing rates in a timely and sustainable way), central banks have allowed bubbles to inflate beyond reason. They neglected to rein in the corporate debt bubble, and now they are compelled to step in to mop things up. That’s the lopsided role they have forced themselves into. “They consider that asset price stability is not their concern, but when a bubble bursts, it’s their responsibility to pick up the pieces, Couture points out. They should practice prevention rather than react in a panic.”
The Bank of Canada is indeed in “mopping up” mode. It recently stated that it will continue its present program of quantitative easing with large-scale purchases of at least $5 billion per week of Government of Canada bonds. “The Bank’s short-term liquidity programs announced since March to improve market functioning (emphasis added) are having their intended effect,” states the press release. It’s helping, but is it a better outcome than if they had acted earlier?
At What Cost
Though he is certainly not indifferent to the idea of asset price stability, “adding it to central banks’ mandate would only complicate things,” judges Benjamin Reitzes, Canadian rates and macro strategist at BMO Capital Markets. He fears that pushing on rates to control asset price inflation would exact to high a price on the economy, especially on employment. “I sympathize with the idea (of asset price stabilization), but I’m not sure if we should bankrupt a lot of companies to achieve it.”
Furthermore, asks Reitzes, “how do you determine where asset prices should be? What metrics should be used? When are prices overvalued? When are they undervalued?”
Couture and Caughlin have ready replies to Reitzes’ objections. Couture claims that you don’t need fancy metrics, just the simple common sense to see what is obvious. “Before 2018, everybody was warning that debt levels were prohibitive: the IMF, the OECD, the BIS, the Federal Reserve.” Central banks had all the necessary ammunition to load their interest rate guns.
As for paying too high an economic price through asset inflation stabilization, Caughlin considers that we are already paying a high price and face the risk of an even higher price to pay down the road. Presently, by acting as a huge market backstop, central banks are pumping artificial life into zombie companies, making price discovery and fundamental analysis obsolete and fostering resource misallocation. “In six to twelve months from now, she says, they will need to pare back, stop purchases and easy monetary policy. The longer they keep that up, the larger the bubble will get.” And the more damaging the burst.
