Central bank competency: Why the visible hand of monetary policy will drive crypto adoption

by Ryan Shea

Key Take-aways

• Investors continue to play the Fed guessing game – will they or won’t they ease? Hard landing versus soft landing?
• Perplexing questions, but even more perplexing is why do we have committee-led monetary policy making in capitalist free market economies?
• Given the critical importance of interest rates in determining our economic well-being, it seems sensible to leave monetary policy decisions to the professionals.
• However, this is only true if they are competent at determining the appropriate level of the interest rate for the economy at any given point in time.
• One way to test this competence is to compare their inflation projections relative to realized inflation. Judged on this basis they have not done terribly well.
• This is because the interaction between interest rates and inflation is not as well-understood as many think.
• If central banks can’t accurately forecast inflation, it naturally follows they can’t be very competent in setting monetary policy either.
• As more and more people come to this realization, it will provide additional impetus to crypto adoption.
• After all, would you like to be in a plane flown by a pilot who doesn’t know what all the buttons and levers do? No - me neither.

After the Fed hand-brake-turned monetary policy in 2022 to play catch-up with surging inflation, the bond market is anticipating another (this time dovish) hand-break-turn to deal with the tension in the US banking system¹, which has already resulted in three fairly sizeable bank failures and, if the surveys are to be believed, is causing credit to be curtailed at a magnitude typically only seen prior to recessions. However, judged by their latest comments, Fed officials are having none of it. In their mind inflation is well-above target – as it has been consistently for two years – and with the jobless rate at multi-decade lows, the funds rate needs to be kept high to ensure inflation converges back to their 2% inflation goal.

As discussed in my last research note my take is that bond investors are probably correct in perceiving the risk of a hard landing as increasing but they are being too optimistic in pricing a swift Fed pivot because the hurdle for easing is much higher than they have become accustomed to for the aforementioned reasons. The implicit, but nevertheless inevitable, conclusion is that the Fed is on the cusp of making a policy error. Am I right? Is the bond market right? Is the Fed right? What is the appropriate level for US short-term interest rates?

Questions, questions, questions.

That got me thinking about the role played by central banks within the modern economy. In many ways they are exceptionally strange entities. Let me explain.

Invisible Hands

Most people who work in finance are accustomed with the concept of the invisible hand, a hypothesis conceived by the moral philosopher Adam Smith (economists didn’t exist at the time he wrote Theory Of Moral Sentiments²). The idea, which has been expanded since it was first outlined, is that individuals acting in their own economic self-interest results in the best outcome for society without them either intending or knowing it, ie, it is an unintended positive consequence.

Although economists have identified several instances of market failures, such as monopolies, negative externalities, inequality etc over the years it is still the foundational argument in support of the free market being the optimal mechanism to “distribute scarce resources in the face of unlimited wants and needs”.

Put within a social context, the invisible hand really is just another way to say that “many heads are better than one”. Of course, self-interested individuals can and do make mistakes, but the assumption is when aggregated up these small (relative to the size of the economy) errors tend to cancel each other out, resulting in the optimal solution being magically revealed in the absence of any organized or explicit co-ordination. Certainly, free markets are considered superior to the alternative centralized model where decisions are made by committees. Isn’t that why capitalism succeeded where communism failed?

And yet, in capitalist free-market economies how do we set monetary policy? By committee. A select group of people are hired to work at the central bank and they are tasked with determining what the price of money (the interest rate) should be. Doesn’t that strike you as odd? It does me.

Good Judgement...

I think we would all acknowledge that the level of interest rates in an economy has a profound impact upon everyone. It influences economic growth, inflation, unemployment, the cost of government borrowing, the cost of household borrowing (including mortgages - the biggest ticket item most people are likely to purchase), the level of asset prices, the strength of exchange rates… the list goes on, and on, and on. We are not talking about something inconsequential. Just as we would not trust a group of untrained members of the public to run a nuclear reactor or fly an aeroplane it seems sensible, if not outright prudent given its importance to our economic well-being, to leave monetary policy decisions to the professionals.

Of course, this only holds if central bankers are competent at determining what is the appropriate level of the interest rate for the economy at any given point in time. The CVs of those appointed to monetary policy committees may suggest competence but the only credible way to judge competence is via their track record.

Since central banks were made operationally independent – a process that began in the mid-1990s - most have adopted an explicit inflation target (typically 2%) and this provides a key litmus test by which to objectively measure their competence.

With the notable exception of Japan, whose economy has been plagued with deflationary forces for decades, since the turn of the century inflation rates in the leading developed economies have been broadly in line with their price stability mandates. (The chart below shows core CPI, which excludes the more volatile food and energy components). That was, of course, until 2022 when the wheels came off and inflation surged to its highest level in decades.

Core CPI Inflation – Major Economies

Source: OECD

... Or Luck?

Clearly the luck of central bankers changed, but is it a case of competent central bankers becoming unlucky, or less than competent central bankers having previously been lucky (in the sense that the past two decades happened to be a benign, low volatility, macro landscape for reasons largely unrelated to monetary policy)? Quite an important difference.

Answering this question requires rather more than simply looking at how much inflation has deviated from its target rate. Inflation can be buffeted by short-term shocks, of which we have had a couple of doozies in recent years – notably the Covid pandemic and the Russian invasion of Ukraine. Crushing economic growth as soon as inflation starts overshooting is probably not the most sensible way to conduct monetary policy. Therefore, a better way to gauge the competence of central bankers is by looking at how accurate their inflation forecasts have been over the past two years because this should take into account their tolerance for overshoots.

Two central banks that produce quite detailed inflation forecasts are the ECB and the BoE, so let’s see how they performed over the recent past – see charts below.

ECB Inflation Forecasts vs. Out-turns

Source: Financial Times

BoE Inflation Forecasts vs. Out-turns

Source: Twitter (@edconwaysky)

What is readily apparent from these charts is that both central banks significantly and consistently underestimated the extent of the rise in inflation rates. What’s more, these two central banks were not alone. Almost all central banks consistently underestimated how much inflation rates would rise.

It is tempting to give central bankers the benefit of the doubt as they were dealing with a very unusual and challenging set of circumstances. However, this apparent inability to forecast inflation is not a new feature. Take a look at the ECB’s inflation forecast track record since 2012 – see chart below. While the magnitude of the errors are relatively smaller (reflective of a more benign macro backdrop) they are nevertheless consistently biased, albeit in the opposite direction.

ECB Inflation Forecasts vs. Out-turns

Source: Twitter

Judged on the basis of these charts, thank goodness the people sitting on monetary policy committees of central banks are not employed in the airline or nuclear power industries.

Fool’s Errand

Interestingly, it is not only central banks who are seemingly unable to forecast inflation. The chart below shows the evolution of consensus private sector forecasts in the US versus actual out-turns. Look familiar? Even large groups of independent individuals – a closer approximation to the invisible hand in terms of macroeconomic forecasts – consistently underestimated the jump in inflation rates.

US Consensus Forecasts vs Out-turns

Source: (I can’t quite remember - I pulled it off google - if you recognize the source please let me know and I will amend).

Forecasting inflation appears to be a fool’s errand. For central bankers this represents a rather serious problem for a subtle and underappreciated reason. Pretty much every financial commentator describes central banks as inflation targetters, but in reality they are no such thing. Due to the long lags which monetary policy impacts an economy – and hence inflation – what they actually are is inflation forecast targetters. That is to say, they set the level of interest rates such that their inflation forecasts hit the 2% goal over their forecast time horizon (typically two years). If they can’t accurately forecast inflation, it naturally follows that they can’t be very competent in setting monetary policy either.

Shaky Foundations

So how come central banks and financial market participants are bad at forecasting inflation? In my view, it is because the theoretical foundation upon which their forecasts are based is – let me be generous – incomplete.

The prevailing model macroeconomists – certainly those employed at central banks - use when estimating the effect of interest rates on inflation is via aggregate demand³. According to this framework, higher interest rates force consumers to use a greater proportion of their income on debt servicing, meaning they have less income available to spend. Given consumption constitutes 70% of the economy, this directly translates into weaker economic growth. Furthermore, faced with less demand, companies (eventually⁴) begin to shed labour pushing up the jobless rate, which serves to further undermine household incomes and hence future consumption. As every student who has ever taken an economics class knows, lower demand results in lower prices, ergo, raising interest rates lowers the inflation rate.

Notwithstanding the intuitive appeal of this logic, the evidence to support it is somewhat patchy. Underpinning it is the Phillips Curve, which assumes an inverse relationship between inflation and unemployment. During the 1970s this assumed negative relationship blew up when unemployment and inflation simultaneously soared. The theory was patched together by incorporating short-run Phillips curves that were dependent upon the level and volatility of inflation expectations.

However, in the post Great Recession period the relationship broke down again. In a blog past last year John Cochrane – a theoretical economist who is a proponent of the fiscal theory of the price level that I have referenced in several earlier research notes – pointed out that between 2007-2019 the Phillips curve became flat only to become almost vertical during the pandemic. Such instability makes the Phillips curve about as useful as a chocolate teapot when it comes to using it as the basis to set the appropriate level of interest rates.

In a more recent blog post John more formally discusses the relationship between interest rates and inflation where, after running through a few Greek filled equations, he concludes:

“The statement that we have easy simple well understood textbook models, that capture the standard intuition -- higher nominal rates with sticky prices mean higher real rates, those lower output and lower inflation -- is simply not true. The standard model behaves very differently than you think it does. It's amazing how after 30 years of playing with these simple equations, verbal intuition and the equations remain so far apart.

In this very standard new-Keynesian model, higher interest rates without a concurrent fiscal tightening raise inflation, immediately and persistently.”

Higher interest rates and higher inflation? WTF. That was not in the plan.

Macro Relativity

In my opinion, one critical deficiency with the way macroeconomists think about the relationship between inflation and interest rates, undermining the policymaking competence of central banks, is they fail to fully consider the impact higher interest rates have on the supply-side of the economy.

Higher interest rates raise the cost of capital to firms, reducing their incentives to investment in new production or economic capacity (aggregate supply in economic speak). Again, as every student who has ever taken an economics class knows, less supply results in higher prices, ergo raising interest rates raises the inflation rate!

Looking solely at the impact of interest rates on aggregate demand is insufficient. It is the relative impact interest rates changes have on aggregate demand and aggregate supply in the economy that determines how inflation moves. If the damping effect from rising interest rates on aggregate demand is greater than the damping effect on aggregate supply inflation rates will fall, if it is less inflation will rise. The relationship between interest rates and inflation is way more complex than we are generally led to believe.

My concern at the present juncture is after such a prolonged period of very low nominal interest rates, many firms have business models that have become heavily reliant on cheap financing and in the face of sustained higher interest rates many may go out of business (not unlike the three US banks that have already failed this year). If correct, it means the damping effect on aggregate supply from higher interest rates would be considerable, meaning inflation could very easily prove to be much more durable than those simply looking at the aggregate demand effect.

So What?

Okay, so as interesting as all this is, what has it got to do with crypto, which is the focal point of these research notes? Quite a lot actually.

One of the biggest criticisms from mainstream economists about crypto, specifically limited or finite supply cryptocurrencies like Bitcoin, is their supply rigidity makes them unsuitable as a form of money. The argument rests on the belief that central banks require the flexibility that comes from having freely-issuable fiat money in order to implement countercyclical policies and smooth out the economic bumps in the road that inevitably occur because the global economy is a highly dynamic, non-linear, near chaotic (in the scientific sense) system⁵.

I would have no problem with this conclusion if central banks were able to demonstrate a solid understanding of how their monetary policy actions impact the economy. But judged on the basis of their inflation forecasting track record it appears they don’t even have the basics down pat. In the aforementioned blog post (see footnote 3), George Copper concludes with the following statement…

“An interesting experiment would be to set central bank base rates to say 3% and then to send our monetary policy committees to the seaside for a decade or two. The economy may perform better without an active monetary policy.”

I would go one step further and say in that case why not just do away with fiat money entirely. Prior to Bitcoin’s release it would be impossible to have money that was not issued and controlled by a centralized entity, such as a central bank, because of the problem of double spends. That requirement has now been obliterated. Blockchain technology, which in Bitcoin’s case has been battle-tested for more than 14 years, allows us to issue decentralized money in a digital form (the form that the vast majority of payments are made in).

Fans of the fiat system argue that having a fixed/limited money supply will result in greater economic volatility (booms and busts) and that it is also almost certainly deflationary, which they worry will undermine long-term economic growth prospects.

On the former point I agree, restricting the ability of central banks to run countercyclical policy would probably increase short-term booms and busts relative to what we have experienced over recent decades. I say probably because as outlined above, we – and by we I include central bankers - still don’t appear to have a good handle on how inflation (the primary focal point of central bankers) and interest rates (the primary policy tool of central bankers) interact, so it is far from obvious that this will be the case.

Moreover, when one takes a step back and looks at the long-run macro trends, it is far from obvious that the current fiscal and monetary frameworks have delivered stability. Yes real GDP growth and inflation rates have been relatively stable over recent decades, but look at what it has taken to ensure that outcome. Government debt-to-GDP ratios have risen to near record peacetime highs and central banks have balance sheets that are far larger than historic norms (exceeding annual economic output in some cases ). Can we really be sure we aren’t simply storing up much greater longer-term volatility?

Perhaps it would be better to have higher frequency, but smaller in magnitude, boom-and-bust cycles that mitigates the risk of accumulating larger macro imbalances whose inevitable correction (economic gravity cannot be defied indefinitely) could have potentially disastrous consequences. For those that still disagree I will just say this: come back to me when debt/GDP ratios are back down to levels that the Europeans considered prudent enough to include in the Maastricht criteria⁶ and then we can talk.

On the deflationary point, I also agree. Having finite-supply money would exert downward pressure on prices because increased productivity would lead to an increase in the supply of goods relative to the supply of money, but how is that a bad thing? Falling prices simply means an increase in the real standard of living. To me that sounds like a good thing.

It would only be objectionable if consistently falling prices prompted people to continue to put off expenditure in anticipation of even lower prices in the future leading to a deflationary spiral. I have come across this argument on many occasions and my response is always this: Have you bought a laptop or pretty much any tech product over the past five years? Of course you have, and that is despite their prices having been on a consistent downward trajectory for decades. As I mentioned earlier, people have unlimited wants and needs and this impetus will always prove to be the dominant force.

Deflation would, of course, also mean that because interest rates would be unable to go negative the real value of debt would increase. But, again, is that so bad? If people were aware that there was no prospect of being given a get-out-of-jail free card in the form of negative real interest rates, perhaps they would be more cautious about borrowing money in the first place and we would not get into situations as we presently are where debt levels are very high but without a clear plan as to how they can be corrected (absent of course the central banks being compelled to hit the button on the printing press).

Co-existence

Will we ever get to see a world where money is freed from the hands of central banks? Probably not. Controlling the money supply is a very powerful tool and governments, who are the ultimate boss of central banks no matter how independent they like to think they are, like and crave power more than anything else. But, the beauty of cryptocurrencies is they can’t stop you or anyone else owning and using them to make payments if you so wish. It is beyond their mandate. More likely the two will co-exist. When I look at how the size of government and central bank balance sheets have expanded over recent decades, I know which one of the two will better satisfy the store-of-value prerequisite for money and it surely ain’t fiat.

Until next time.

Ryan Shea, crypto economist

1By year-end US interest rate futures are pricing in 50bp of easing – see: https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html

2Adam Smith is more well-known for his book The Wealth Of Nations but it was his earlier work where he first mentioned the phrase.

3I am not alone in thinking such heretical macroeconomic thoughts. In a very interesting article George Cooper, a respected fund manager and investment strategist, added a further effect that I hadn’t considered but which is pertinent given the “Greedflation” narrative. Faced with higher debt service costs “producers attempt to pass on these higher costs through higher prices and, as competition is less intense, find it easier to do so.” - see: https://www.equitile.com/article/are-central-banks-causing-stagflation

4Due to labour hoarding.

5Anyone with any familiarity with chaotic systems knows it is impossible to use them to predict anything because changing the inputs by only a tiny amount generates radically different outcomes, a bit like hash functions radically change when the input is only slightly altered.

6For the record 60%.