Everyone believes that the modern central bank is an omnipotent economic force. What if it isn’t? What if it can’t even do the most basic of things that it says it can – control interest rates?
A quick and easy way to see if central banks really have more insight into the future is by looking at their forecasting record.
Since inflation tends to be their mandate and main focus, let’s take a look at how their forecasts panned out.
Beginning with the Fed, the chart below shows the FOMC’s projections of the percentage change in the Core PCE on a yearly basis (a year as measured from one 4th quarter to the next), compared to actual readings of the Core PCE data series.
The shaded area represents the difference between the High and Low central tendencies of that forecast for a particular year.
The Fed establishes the central tendency of its Core PCE forecasts by excluding the three highest and three lowest projections.
We can see that their forecasts have not been very accurate.
If they had been, then the line representing the Core PCE (purple) would sit firmly in the shaded area, between the high and low central tendencies. Instead, we see that the Fed has consistently forecast inflation to be higher than it turned out to be since 2004.
In addition, the FOMC has not been able to forecast steep falls in the Core PCE during the two crisis periods in the data set, 2008 and 2020.
This is related to them following, rather than leading, the market in terms of setting interest rates. The Fed only cut the Fed Funds Rate in an appreciable manner after the market had already made its high, in the run up to both events.
Which really is another way of saying that the Fed did not, and cannot, forecast future economic crises.
What about other central banks, like say, the ECB?
Unfortunately, the Europeans don’t fare much better, with their forecasts also consistently differing from actual inflation readings.
From the chart above, we can observe that in the years leading up to the Great Financial Crisis to about the end of the Eurozone sovereign debt crisis, the ECB consistently underestimated inflation. Then, in the years after, they have consistently overestimated what the HICP would turn out to be.
Note that the chart depicts the Winter series of projections made by ECB staff for annual changes in the HICP. Also, the HICP series plot reflects the annual change in the Overall Index for the Euro Area as a whole, taking into account the changing composition of member states over the years.
The point of all this is to demonstrate that central banks really experience the same problems as everyone else when it comes to forecasting – doing it accurately, much less consistently, is an impossible endeavor.
This, however, is not an indictment against them, since they are human after all, and cannot see into the future.
However, implicit in the widespread belief that central banks make effective policy decisions is the acknowledgement that they can predict what will happen, at least to some degree. But as their inflation forecasting record clearly shows, they can’t.
Why then do people continue to trust that they can?
What are the implications of central banks not being able to control interest rates, like almost everyone thinks they do?
Seeing central banks as just another participant in the financial system, albeit an influential one, leads to some interesting insights, especially with regards to the USD.
For one, the Fed’s (and central banks’) greatest detractors are detracting against the wrong entities.
These detractors tend to be “hard money” folk, who view the existence of central banks, particularly the Fed given its global influence, as guardians of the paper money regime.
Accordingly, the hard money folk have a tendency to view central bank policy making through the lens of currency devaluation, and strongly advocate for a return to an era of “hard money”. That is, a currency that is backed by gold and/or some other precious metal(s).
In the United States, such sentiment is expressed most stridently by people who criticize the Fed for embarking on loose monetary policies that will further devalue the USD.
Low interest rates, QE, and keeping the Fed Funds Rate too low for too long are all examples of the major criticisms the hard money crowd has levelled at the Fed over the past decade.
But, the USD hasn’t actually lost value since the Fed embarked on QE in the modern era.
Looking at long term trends, the USD has actually gained in value against a basket of international currencies.
The reason for the USD’s decade-long rally in spite of ever larger iterations of Fed QE is quite simply that the Fed does not sit in the middle of the financial system!
It’s policies do not control interest rates, much less the value of the USD.
Hard money folk think the Fed is omnipotent and controls America’s monetary destiny, when in truth, it does not, at least not if it continues to think bank reserves are all that matters to the financial system.
Consequently, the Fed’s detractors are as bought into the inaccurate worldview of central bank omnipotence as its supporters.
The detractors’ real opponent isn’t the Fed, it’s the entities that actually create money in the system – banks. This will remain true as long as central banks continue to cling to the conventional dogma that overemphasizes the importance and utility of bank reserves.
Of course, this will change should the Fed or other central banks switch their focus away from fractional reserve banking to how money is really created, that is, ex nihilo.
Since this means switching from controlling levels of bank reserves to setting policy based on levels of bank loans, it involves quite a drastic change in central banking Paradigm, which unfortunately is extremely difficult to achieve.
QE doesn’t work, at least not in the sense of fulfilling its objectives as a policy choice.
These would be, broadly, higher economic growth, higher employment, and higher inflation (the good kind).
In short, QE is supposed to be a monetary bazooka that does magical things. Instead, it’s been more magical thinking, not doing much good, while creating serious unintended consequences and second order effects.
Would it be better for central banks to just not do anything?
Doctors have a term for this, iatrogenesis, quite possibly first introduced into the financial lexicon by Nassim Taleb in his book “The Black Swan”, which describes QE’s effects very well.
Iatrogenesis, in the medical context, simply means the causing of a disease, complication, or negative effect by any medical activity. “Any” here encompasses the full suite of actions doctors may or may not take, from diagnosis, intervening action, making mistakes, or simple negligence.
In other words, it’s about taking action and having things not work out because of that action.
It is important to note that there is often a long chain of events between action and unforeseen/undesirable consequence, where different decisions could have been made to change the course of events.
But, there are also instances where the consequences can be quickly and directly traced back to the initial action, and QE falls firmly into this category.
QE actively makes the repo market unstable with all sorts of nasty, and more importantly, global, consequences.
By purchasing USTs, the Fed removes the primary form of collateral used in the repo market, which increases the probability of a collateral squeeze. Should markets be overly leveraged and overly bullish, such a squeeze has the potential to quickly snowball into mass liquidations which cascade through multiple asset classes globally.
Also, since the majority of market participants believe that QE is magical, they are predisposed to being overly bullish when a central bank announces yet another iteration of QE.
It’s almost as if policy makers want to set the system up for fragility and future failure.
Take a moment and consider the ramifications of this – that 1) Central Banks do not understand how money is created and how the financial system actually works, or 2) they do understand it but are not tailoring their policies to reality.
If 1) is true, then what good are these QE loving Central Banks doing?
If they do not understand the very basics of how the system they are overseeing works, that means that all their future monetary policies are dead on arrival, not to mention the decade(s) already gone.
On the other hand, if 2) is true, then it begs the question – Why?
A possible reason is that Central Banks feel the need to be actively doing something, which is after all a very normal emotional reaction all humans have in times of crisis.
Which brings us back to iatrogenesis.
Taking action because one feels that one needs to take action, or even worse, because one doesn’t want to be perceived as not taking action, surely counts as a poor reason for doing so.
This is especially the case when considering that QE doesn’t do much good, but still causes debilitating second order effects (e.g. reducing repo collateral).
The risk-reward of the policy is clearly off, so why persist with it?
Wouldn’t it be better for central banks to simply not do anything, at least until they figure out a course of action that is, at the very least, not harmful?
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