Unintended Consequences:
Policies and Inflation

Growing fragility of the global financial system as a result of highly experimental and radical monetary policy

By Mark A. Stairs, B.Eng., CFA.

July 10, 2023

For many years now, I’ve re-iterated my concerns about the growing fragility of the global financial system as a result of what I have characterized as highly experimental and radical monetary policy executed by the globe’s central bankers: the pack leader being the Federal Reserve, of course.

Those in my camp have for years been labeled as ‘perma-bears’ or ‘glass half emptiers’ as central bankers printed tens of trillions of dollars seemingly without consequence: of course, nothing could be further from the truth. Generally, you need to be optimistic to be an investor. Nobody invests their (or other people’s) hard-earned money with the expectation of loss. However, there are periods when caution is definitely warranted. I’ve found that those who have been most cautious, are those that have managed client money through several market cycles. That is managers that have been in the markets for 40-plus years.

Nothing is as expensive as free money, and the costs of the Federal Reserve’s zero-interest policy are multiplying…

              Kevin Warsh, former Federal Reserve Board member – Wall Street Journal March 19/23.

Inflation is the Key

The 30 to 60-something crowd, now managing most of the globe’s assets, simply do not have any experience with inflation. It is the resurgence of inflation after a 30-year hiatus and our efforts to contain it, that are now causing problems for asset managers.

All Decisions Have Consequences. If you decide to skip lunch there will be consequences, however, its impact carries little weight. If, on the other hand, you are setting interest rates for a country, the consequences of such decisions have a very real impact on the lives, businesses, and investments of millions of people. Typically, policymakers make decisions, be they monetary or fiscal, with a targeted short-term outcome in mind. Unfortunately, their short-term focus precludes them from considering the longer-term unintended and unforeseen consequences of their decisions. I know, nobody has a crystal ball, but you don’t have to be a rocket scientist to intuit that holding interest rates at zero for a decade is going to have some important, longer-term unintended consequences.

‘Holding interest rates at zero for a decade is going to have some important, longer-term unintended consequences.’

Trying to control the Uncontrollable

The very idea that you can model, typically in a reductive fashion, something as complex as our economy, smacks of hubris to me. Furthermore, to then use these very models to make decisions, that you hope will affect the lives of millions in a positive way more efficiently than free markets seems like wishful thinking.

Ludwig Von Mises, a major thought contributor to the school of Austrian Economics, argued precisely that. The free market comprised of billions of transactions conducted by self-interested individuals is:

1. too complex to model with any predictive accuracy
2. left to its own devices, it is a self-correcting system that constantly adjusts price signals
3. as efficient a system as could be expected, and that government interference can only result in less efficiency.

Bodies floating to the surface

Jay Powell is now trying to reverse more than two decades of central bank interference and the bodies are starting to float to the surface. His efforts to fight inflation, normalize interest rates, kill the notion of a Fed put—market participant’s belief that the Fed will come to the stock market’s rescue on any meaningful decline with a fire hose of cheap money to pump asset prices back up—and shrink the Fed’s bloated balance sheet without cratering the economy, causing a sovereign debt crisis, a banking crisis, a currency crisis and/or a housing price collapse, etc., is just too much to ask in my view.

‘The very idea that you can model, typically in a reductive fashion, something as complex as our economy, smacks of hubris…’

We are just beginning to see the vast and deep seeded longer-term impacts of fooling with the two most important prices in our economy: the price of money (interest rates) and the price of oil (SPR releases and the mad dash to decarbonize).

October 2022 marked the first body to rise from the depths, the British pension system. I wrote about this in the fall issue of TFI, Paradigm Shift, so I won’t rehash all the gory details again but suffices to say that 1.5 trillion pounds of government employee pension plans were imperiled by the Bank of England’s inflation-fighting rate increases and the government’s budgetary madness.

Then in November, we had the collapse of cryptocurrency exchange FTX, a total fraud estimated at roughly 30 billion. Adverse market conditions tend to expose Ponzi schemes of the time. Just like the falling stock market quickly lead to Bernie Madoff’s fall, rising rates this time rapidly exposed FTX’s fraudulent activities. More outright frauds will be exposed in the coming months and quarters, I am sure.

‘…the current environment is a really fertile field for people to play fast and loose with the truth, and for corporate wrongdoers to get away with it for a long time…..its a fake it until you make it culture….exacerbated by lax regulatory oversight….we are in the golden age of fraud’
Harriet Agnew interview with famed short seller Jim Chanos, who made a fortune for his clients on the collapse of Enron – The Financial Times, July 2020

‘We are just beginning to see the vast and deep seeded longer-term impacts of fooling with the two most important prices in our economy: the price of money (interest rates) and the price of oil.’

Simultaneously, we’ve had the growing European energy crisis in 2022. Many people want to blame the war in Ukraine for this crisis. But the reality is that the seeds of this crisis were sown many years before by misguided and politically expedient government policies discouraging the development of fossil fuels before the inevitable energy crisis would manifest. Only the mildest winter in more than 40 years helped Europeans avoid complete catastrophe. I doubt the Eurozone with get that lucky two winters in a row, thus I fully expect energy problems to come to the fore again heading into the winter of 2023/24.

Banking Crisis Averted?

In March 2023 we had the high-profile failures of Silicon Valley Bank and First Republic Bank. Unlike the GFC, the balance sheet problems were not a function of holding a portfolio of garbage sub-prime mortgages but rather a decline in the fair market value of their high-quality US treasury bond portfolio as a result of rapidly rising rates in 2022. All banks face this problem to a certain degree, and larger money center banks have more levers to pull such as sophisticated hedging practices and raising banking fees to help offset portfolio losses.

Nonetheless, unless banks start to raise the rates they pay depositors on checking and savings accounts they will continue to suffer a drain of deposits to money market funds, treasury bills, and short-term bond ETFs. Either they pay customers higher rates and see their profits squeezed or face realized losses on bonds they must liquidate to meet fleeing deposits. A lose-lose situation for banks and more unintended consequences of a decade-plus of central bank zero interest rate policy.

Millennials Priced out of Inflated Housing Market

Millennials, the largest demographic cohort by number continue to be priced out of the property market. Indeed, the American National Association of Realtors reported January figures for their Housing Affordability Index which hit its lowest reading since the 1980s era of double-digit mortgage rates. This is despite a roughly 10% price decline in the median home price over the past year.

In an era of aging demographics, worker shortages, and restrictive immigration policy, a gross lack of housing affordability has negative implications for family formation, workforce participation, and wage inflation. These housing market problems, can in large part, be once again, linked to the unintended consequences of more than a decade’s worth of zero interest rate policy.

Canada’s solution to housing unaffordability: stoke even greater demand and therefore more home price inflation, using taxpayer money to subsidize the introduction of First Time Homebuyers Savings Accounts. Good grief Charlie Brown.

Central bankers are not your friend. Sincerely, Mark

Image courtesy of BMO Nesbitt Burns

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