Heisenberg Report

‘Spaced Out’: Don’t Bring A Knife To A Gunfight.

How many times have we said it?

At this point, the future of risk assets depends almost entirely on whether policymakers can replenish their countercyclical ammo in time to combat the bust the will almost invariably follow from the boom those same policymakers engineered by deploying that very same ammo.

Note the circularity there. That’s the “double-edged sword” dynamic that’s part and parcel of an untethered regime.

An unanchored system (i.e. a system that is not based on a universally accepted, finite store of value like precious metals) affords policymakers with a significant amount of flexibility when it comes to combatting downturns. In short, the “toolbox” (if you will) that comes with the adoption of an unanchored fiat system includes the option to resort to unchecked credit creation in case of emergency.

The problem is that breaking the glass on the emergency toolkit (and there’s a “broken window fallacy” joke in there) means resorting to policies that, while stimulative, create speculative excess. Speculative excesses sow the seeds for the next crisis and so, it is incumbent upon policymakers to unwind the stimulus before the excesses they created cause the next bust. If they miscalculate and the policy response to the previous crisis isn’t unwound by the time the excesses created by that same policy response manifest themselves in a new crisis, they will find themselves out of ammunition.

Of course the vestiges of crises past always linger – creative destruction isn’t a viable option in the modern world. That means that by definition, future crises will be i) inextricably linked to their predecessors, and ii) more spectacular than those that came before. That second point (i.e. the idea that a defining feature of a fiat regime is a rolling boom-bust cycle that snowballs with each turn) means that policy responses will need to grow in magnitude over time to keep pace with ever larger busts. Eventually, the busts become so large that the policy responses required to combat them become caricatures of themselves that border on the absurdity you find in cartoons depicting Ben Bernanke dropping money out of a helicopter.

Well, in a new note out on Monday, BofAML is out asking one of the only questions that matters: “Are central banks spaced out?” Consider this:

For governments to deal with economic and financial crises they need adequate “policy space” going into the crisis. For fiscal policy, this means keeping deficits and debts under control in good times so there is room to apply fiscal stimulus in bad times. For monetary policy it means having high enough interest rates when the economy is healthy so they can be cut enough to also provide real stimulus. In a world of unconventional policy that means having not only a high enough policy rate, but also high enough long term interest rates so that QE is effective in lowering the long end as well. Historically central banks have been able to cut their policy rate by 500 bp during downturns and only recently have they had to rely on QE and other unconventional policy.

Right. And you can probably tell where this is going. Here’s the problem:

One of the striking things about the current exit strategy for many of the major central banks is how little focus there is on future policy flexibility and space. This isn’t an immediate problem: given the strong growth momentum, policy easing is not needed. However, it is a big problem if there is a regional or global shock in the next few years. In effect, the major central banks have tied themselves in a rhetorical knot. With the yield curve already pegged at zero, the BOJ has almost no room to ease. The ECB has accepted a rigid political constraint on QE: absent a politically difficult change in their rules they will run out of QE ammunition by the end of next year. Meanwhile, the Fed seems a bit more concerned about the lack of space, but has signaled a largely pre- determined path of balance sheet shrinkage and has made it clear that rate hikes will continue—at least for a time—regardless of inflation readings. Central banks in many other advanced economies have near zero interest rates as well.

And see, this brings us back to the most absurd part of this entire system. The policy response serves to engineer booms. Booms invariably lead to busts. When the bust comes, you need to deploy those same policies again. But when those policies were the cause of the boom, it necessarily means that the act of unwinding them may accelerate the time table on the bust.

So what do you do? There are no “good” answers, although BofAML does attempt to list a few options. The bottom line though, is this:

The immediate challenge for central banks is the fact that inflation and interest rates are so low this late in the business cycle when they normally would have already been “rearming” for the next recession.

Don’t bring a knife to a gunfight. And don’t bring ZIRP and a still-bloated balance sheet to a recession.