The ever-shrinking options facing central bankers are becoming a problem with extreme consequences for today’s investors. In this post, we consider the trade-off central bankers confront and the impossible decisions they must make regarding your financial future.
On one side is inflation, which can cause economic chaos in numerous ways. Tighter monetary policy is, of course, the solution to inflation. However, increasing the cost of living as a means of combating it is patently absurd. So how does adding interest expenses help alleviate high prices? It doesn’t it only makes the problem worse.
This is doubly true since the inflation we’re experiencing is primarily due to supply shocks rather than demand spikes. Hiking interest rates only works when excess demand causes inflation. Furthermore, businesses that utilize debt to finance inventory would pass on higher expenses to consumers, resulting in further price increases.
Lower Inflation by Reducing Lending and Spending
The only way higher interest rates lower inflation is by reducing lending and spending, but these adjustments take an extended period to impact the economy, especially when lending and spending aren’t the root of the issue.
The US Federal Reserve’s hiking cycle began in March 2022, so we must wait an additional six months before the monetary policy takes effect. Only then, theoretically.
Banking crises are incredibly deflationary since they reduce the money supply as multiplied by the banking system. Banks create money each time they issue a loan. When the banking system falters, less money is created, which is detrimental to the economy and money supply.
Central banks are responsible for keeping the banking system liquid to prevent crises, but they must create money to do so, which is inflationary. Whether the US Federal Reserve’s most recent bank rescue package amounts to quantitative easing (QE) is beside the point. The central bank’s balance sheet has already ballooned by hundreds of billions, which is inflationary.
Which would you choose: a banking crisis or an inflation crisis? Historically, central banks’ primary function was to safeguard the banking system and government debt markets. So, it’s less evident what central bankers should do than “focus on inflation as it says in your mandate, you fools!”
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Central bankers are easy to blame for the current predicament. They caused both problems—inflation and the banking crisis. They created inflation with loose monetary policy, ignored it when it surfaced, promised not to hike rates to combat inflation, then did precisely what they promised not to do.
As a result, we have high inflation and plummeting government bond prices. Higher interest rates cause bond prices to drop, and falling bond prices make the banking system fragile by inflicting losses on their vast bond holdings.
You might also argue that central bankers were responsible for creating the bank regulatory environment that encouraged holding so many government bonds in the first place. In addition, US central bankers mishandled the banking crisis, allowing some banks to fail, insuring some deposits but not others, and continually changing policies, creating an opening for the crisis to persist by rescuing small banks.
In Europe, central bankers created a great deal of uncertainty about convertible bonds, which is part of the Basel II framework. This creates another avenue for the banking crisis to persist.
So, should we just blame central bankers? Perhaps not. Instead, we must figure out what to do. Just as 2022 revealed simultaneous stock and bond meltdowns (which weren’t supposed to happen), the next few years may upend investment principles.
Safeguarding savings during uncertain financial times is where investing in Gold can provide a viable alternative.
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