In a recent note, Eric Peters, CIO of One River Asset Management, summarizes everything that's been happening over the past few years in one tidy anecdote. Citing an unnamed CIO, he points out that the central bank was created to help its member banks, and it attempts to impact the real economy by using interest rates as a mechanism to control the attractiveness of lending money. However, throughout all of the meticulous planning done by the creaters of the Federal Reserve, nobody bothered to ask what would happen if the central bank suddenly couldn't influence the attractiveness of lending money, thus not being able to affect the real economy - which is precisely where we are today.
From Eric Peters:
“Central banks were created to be the banks for banks,” said the CIO. “They were structured to influence the economy by increasing or decreasing the attractiveness of lending money.” If central banks wanted to spur banks to lend to the real economy, they reduced the interest rate they could earn from parking their money at the central bank. If they wanted to reduce bank lending, they increased the attractiveness of making risk-free loans to the central bank by raising interest rates.
“But no one ever asked the question of what to do if the central bank was somehow unable to increase the attractiveness of lending money? If that happened, how could central banks influence the real economy?” Which is basically where we are today.
“It’s one of those questions that seemed so implausible that no one ever really considered it.” With central banks perplexed by this dilemma, they turned to negative interest rates. Hoping that by taxing banks for keeping money with the central bank, they’d spur lending to the real economy. “But by going negative, they simply push longer-dated interest rates lower, further reducing the attractiveness of making loans.”
By reducing the yield on every investment asset, pushing prices to overvaluation, this policy also destroyed the ability of investors to build diversified portfolios capable of withstanding even the slightest economic disruption. Which ultimately results in reduced private sector risk-taking; the lifeblood of every economy. “This is the most obvious disaster in finance. Central bankers don't quite understand it.”
It’s one of the key reasons Japan and Europe are performing so poorly.
“They never thought this through. And they should probably give up and raise rates to reverse this dynamic.” But that will cause extreme volatility. “And the irony is that central banks are creating precisely what they’re trying to avoid.”
We would just add that in addition to the the inability to control the attractiveness of lending money, what the central planners also overlooked (and continue to ignore) is, more importantly, the fact that central banks can not create individual demand. A bank can lend at whatever rate it chooses, but if there is no demand for that loan, the game comes to an abrupt end.