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Unfortunately, It's All About The Central Banks

The following is excerpted from a commentary originally posted at www.speculative-investor.com on 5th August 2012.


The senior central banks choose not to do more damage immediately

As expected, the Fed took no action last week. At the moment it is offering only words. For example, the statement issued last Wednesday after the FOMC Meeting included the words "The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed". This is just a statement of the obvious, because "the committee" is always closely monitoring incoming economic information and will always provide additional accommodation as needed. After all, there is no limit to the amount of so-called accommodation that can be provided by the Fed.

In this case, "accommodation" is such a poor choice of word it is almost Orwellian. When the Fed plays around with interest rates and the money supply in its efforts to "accommodate" the economy, it damages the economy. The more it tries to accommodate, the more inaccurate the interest rate and other price signals become. This leads to a greater number of wrongheaded decisions being made by businessmen and investors. If the accommodation happens during normal times it will lead to an obvious "price inflation" problem within a few years, but if it happens during a major de-leveraging (a period when the private sector is attempting to clean-up its collective balance sheet) it will get in the way of the corrective process and delay the start of a sustainable recovery.

The day after the US central bank promised to do more if necessary but nothing immediately, the euro-zone (EZ) central bank did the same. The ECB's decision not to immediately boost its "accommodation" was more surprising than the Fed's, because a week earlier Mario Draghi had excited the markets by saying that the ECB was ready to do whatever it takes to reduce the borrowing costs of financially-stressed EZ governments and support the euro. At this stage, doing whatever it takes apparently means taking no immediate action.

Things are more complicated for the ECB than for the Fed. The Fed can essentially do whatever it likes as long as what it likes isn't in conflict with the short-term goals of the US federal government, but the ECB can't support the bonds of one EZ government without blatantly imposing additional costs on the taxpayers of other EZ governments. It therefore often finds itself torn between the conflicting goals/desires of different governments.

Right now the best indicator of financial stress within the EZ is the yield on the 10-year Spanish Government Bond (see chart below). When no immediate action was announced at the conclusion of last Thursday's ECB meeting, the yield on the 10-year Spanish government bond moved above 7%. This prompted declines in the euro and most stock markets. For some unknown (to us) reason, however, the yield on this bond dropped back below 7% on Friday, prompting strong up-moves in the euro and most stock market indices. Perhaps the ECB took some action after all.

Spanish 10-Year Bond

The stock market and the central bank

The slowing growth or accelerating contraction in Europe, the US, China and many other parts of the world is due to real problems. It isn't due to depressed confidence and therefore it can't be permanently reversed by boosting confidence. In fact, boosting confidence to the point where the problems are ignored could only lead to imprudent decisions, thus destroying more wealth and further weakening the economy. In other words, the problems that are weighing on economic growth wouldn't magically disappear if everyone were injected with 'happy juice' or visited by the 'confidence fairy'.

In addition, the problems couldn't possibly disappear as a consequence of central bank money creation. Money is just the general medium of exchange, so manipulating the supply of money can only act to distort the price signals upon which the economy relies. Causing distortions to price signals prompts bad decisions and the destruction of real wealth. In fact, rather than being a potential solution, monetary inflation is the most important CAUSE of the current problems.

That's economic reality. Economic reality dictates what SHOULD happen on the policy-making front, but due to a combination of ignorance and Machiavellian politics there's often a big difference between what should happen and what will happen. The sad truth is that there WILL be a lot more monetary inflation in the future. The only question is: when? The best answer that we can come up with is: within the next two months for ECB-sponsored inflation and after the stock market tanks or the backward-looking economic data gets much weaker for Fed-sponsored inflation.

In the mean time, expectations regarding central bank machinations are by far the most important drivers of stock market performance. The performances of individual shares can still be affected by company-specific developments, but the overall market is rising and falling in reaction to changes in expectations regarding what the central banks will do and when they will do it. To put it another way, the stock market no longer serves as a vehicle for the efficient allocation of capital to businesses. It is now almost solely an instrument for speculating on the decisions of a small group of official price manipulators. That's one reason why the bull market in gold is not remotely close to being over.


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