Markets

Markets don’t share Draghi’s taper terror

They say you should learn from mistakes. But what if a “mistake” isn’t really a mistake? What if the error is thinking that it’s a mistake? 

In June, Mario Draghi, chief of the European Central Bank, supposedly erred by hinting that quantitative easing (QE) could soon stop. Long rates rose throughout Europe, steepening the yield curve. People freaked. So he reverted, saying inflation is not where he wants it and QE could increase. I’m reminded of Albert Einstein’s supposed definition of insanity: doing the same thing over and over and expecting different results. 

Last time I checked, central bankers’ primary goal was stable money. Yet Janet Yellen, chair of the Federal Reserve, can’t stop talking about inflation being under 2 per cent. Mr Draghi thinks stable prices are a drag. Both have the dream scenario of reasonable economic growth with stable prices. Yet neither seemingly notices. 

This would be hilarious if central bankers didn’t see price stability as a problem to be solved. The Fed’s phobia of low-flation gave us years of QE and unnecessarily low interest rates, extending fears that the US needed “stimulus” to grow. The uncertainty was unnecessary. Mr Draghi’s similar obsession gave the eurozone a one-two punch on QE and negative rates. 

Mark Carney, governor of the Bank of England, seems the most sensible of the bunch, agreeing to the smallest QE restart in history right after the Brexit vote, when folks would have crucified him for doing nothing, then letting it quietly expire six months later. Mr Draghi should take a hint. QE has lasted way too long in Europe. 

Central bankers miss a basic truth: inflation derives from excess money supply growth and lending, at a slight lag. It’s basic Milton Friedman. Inflation is always and everywhere a monetary phenomenon — too much money chasing too few goods. Since banks create almost all new money in fractional reserve systems such as the US and Europe, loan growth means money growth — pumping prices higher. Simple.

Over a century of data shows steeper yield curves — bigger gaps between short and long rates — generate more bank lending and faster growing economies. Banks borrow at short rates, lend at long rates and profit from the spread. The bigger the spread, the more banks magically multiply reserves into new broad money, lent to households and businesses. Those loans morph into investments paying off hugely over time — new factories, software, equipment, research, product lines, the works. 

So for Mr Draghi, the solution is one I’ve preached here before: think like a banker and stop the QE madness. Stop buying long-term bonds, stop depressing long rates, and let the yield curve steepen. Money supply should grow, spurring growth.

Brits are living this now, though few realise it. For all the talk of weak sterling driving inflation, lending and broad money supply (M4) have surged over the last year. M4 has grown at an annualised rate of 6 per cent or faster every month since May 2015.Loan growth year-on-year ranged from 3.9 to 6.9 per cent. Hence it would be odd if inflation didn’t speed up. Soon this lending should flow to business investment and feed faster growth. Be patient. Remember higher inflation rates in 2011 and 2013 didn’t derail Britain’s economy or markets. 

Europe is already demonstrating the power of less QE. Eurozone lending has improved since Mr Draghi cut the pace of bond purchases last December. Banks are loosening, though loan growth rates are slower than in the US and Britain. Both would bemoan 3 per cent year-on-year loan growth, which the eurozone “achieved” in May, with business lending still negative in some countries. If the bloc could still average 1.8 per cent GDP growth with lending so weak, imagine how fast it could grow once the ECB stops sucker-punching banks.

People worry that higher long rates will deter borrowers, but they shouldn’t. Can you imagine a legitimate business whose long-term prospects suddenly turned ugly because borrowing costs inched higher? If slightly higher long rates make a long-term project unprofitable, it wasn’t worth doing anyway. 

The US and Britain provide all the proof you need. After both stopped QE years ago, lending and money supply sped up. So did economic growth. Stocks loved it, too. If the ECB can get over QE, we can all finally forget the nonsense of negative rates because yield curves should steepen enough for banks to lend freely. Europe will no longer be in this whacky warped state where loan growth of 3 per cent is seen as something to cheer. 

Presuming they ever figure it out, that is. The US made the QE mistake, learned the lesson and stopped the madness. So did the UK. But the continental central bankers haven’t learned and maybe won’t ever. Being tethered to a stubborn behemoth surely can’t be fun. Is that a singular reason for Brexit? 

Ken Fisher is the founder and executive chairman of Fisher Investments and chairman and director of Fisher Investments Europe. Twitter: @KennethLFisher

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