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Central Banks: The Farce That is Bernanke, Fiscal Dominance and Forecasting

Aug 10, 2023, 4:29 pm BST

All developed economy central banks have come to, or are fast approaching, the end of their tightening cycles. On the face of it, many are congratulating themselves for a “job well done”. Yesterday’s US CPI data will almost-certainly exacerbate these misconceptions. 

But of course not all developed banks are feeling like they may have achieved something. Despite facing very similar external challenges to the rest of the developed world, the Bank of England has done a beyond appalling job of getting on top of inflation, as well as managing the market’s expectations about its forecasting abilities. 

So bad is the job Andrew Bailey’s staff is doing that they have decided to bring in…drum-roll please…Ben Bernanke. Yep, former Princeton Professor,  Fed Chair and Nobel Prize winner Ben Bernanke will spend the next year looking at the central bank’s forecasting tools. Threadneedle Street has come under repeated criticism for failing to predict (and, therefore combat) the UK’s persistent inflation problem. 

As members of the MPC told the government back in May, current forecasting models are  ‘based on the past 30 years’ and therefore struggle when it comes to ‘very big shocks’.

Therein lies the problem with modern-day economics and economists. They think they can predict the future. If anyone has learnt anything in the last couple of decades it is surely that shocks cannot be predicted.

You can’t predict shocks. The Oxford Dictionary defines a shock as “a sudden upsetting or surprising event or experience.”

Bernanke didn’t win the Nobel Prize for Economics because he did a great job forecasting or for predicting shocks, he won the Nobel because he:

“…demonstrated how failing banks played a decisive role in the global depression of the 1930s. Bernanke’s research shows that bank crises can potentially have catastrophic consequences. This insight illustrates the importance of well-functioning bank regulation.”

Why is Bernanke an internationally known economist? Because he was Fed Chair. What happened when he was Fed Chair? Oh yeah…he was so out-of-touch with his own country’s financial system that the sudden demise of Lehman Brothers (two years after he took up his post) caught him by surprise. Even then the global contagion that followed proved to be just as much of a shock to him. 

To be clear: Bernanke missed (i.e. failed to forecast) the worst recession since the 1930s. And then he got a Nobel Prize for telling us how bad the 1930s and subsequent crashes were. 

But What Does All This Mean For Gold?

Often people think of August as a quiet month. It’s the height of the summer period, many children are out of school, people are away from their desks for extended periods of time and the politicians are on summer recesses. What does August mean for gold? Probably much the same as everyone else. 

Gold gave a robust performance in the first half of the year, signing off as one of the top performing assets for H1. With some caution the WGC informs us that in the last twenty years the month of August (along with January) is one of the strongest months for gold returns. 

However, they believe that this month may buck the trend on account of weaker demand in India and China, as well as expected equity and US Treasury performances. 

There are of course many positives going for gold, even if it remains in its current narrow range. If anything we would argue that August presents a buying opportunity ahead of what will almost certainly be a tumultuous few months ahead. 

It takes time for monetary policy to really feed through an economy. Headline inflation figures might be coming down, but that’s about all there is to say about central bank interventions, of late. This is why many committees are adopting a ‘hold-and-see approach’ until 2024. 

Research from the World Gold Council shows that during Fed periods of ‘on-hold’, gold has performed well, delivering positive average returns. 

But one unsurprising phenomenon that has not been taken into consideration is fiscal dominance, an absurdity that makes one wonder if central banks could render themselves any more pointless. 

Fiscal Dominance – it’s not kinky, it’s the economy stupid

The term “fiscal dominance” had been gathering dust for some time amongst theoretical text books until last autumn when short-lived UK Chancellor Kwasi Kwarteng did an absolute number of the UK economy and suddenly everyone was anxious about Fiscal Dominance and wondered if the MPC would be required to enter some kind of sordid dungeon.  

What actually happened was the Bank of England was forced to diverge from its QE unwinding program, instead bailing out the UK economy on account of Kwarteng and Truss’s idiocy. The government’s fiscal actions threatened the bank’s own remit: hence fiscal dominance.  

Now, people are even more worried about fiscal dominance sweeping through the developed world (and therefore the globe). Currently the US is carrying a public debt bill to the tune of $33 trillion. Obviously, the cost of servicing that debt has become mind-bogglingly expensive. So, what do governments ask from their ‘independent’ central banks? To please inflate the debt away. They won’t raise rates enough, or they will print more money, in order to devalue the level of debt. 

What’s concerning about this is that it’s ultimately a political game. Just as we saw when QE was rolled out, policy makers are not going to ask if taking certain steps are right or wrong, no they will just ask themselves “how much can we get away with?”. And you can be sure that the people at the end of the phone asking that are the politicians. 

There’s no quality here 

Of course, unlike central bank issued currencies, gold’s quality and quantity are controlled. It’s not that it’s going up or down in value this month, it’s how badly fiat currencies are doing relative to the yellow metal. It’s how badly those fiat currencies are being managed. 

Here’s the thing with paper money – you can either control the quantity or the quality. It’s very difficult to keep both closely aligned. 

Since 1971 (or arguably, since Bretton Woods) central banks have driven an ever-widening wedge between the desire to maintain the quality of a currency and the quantity of it that is available to the market. Instead, central banks rely on the ability to increase the quantity of cash available whether 

Bernanke’s famous quip, “QE “works in practice, but it doesn’t work in theory”. Is spot on if you’re looking to inflate the economy, reduce the value of the debt and increase government spending. But it also does absolutely nothing to help you or the economy in the long run. 

A justification for fiscal dominance will always be there. And because of the nature of political cycles, there is always a government with different agendas and different demands, all demanding huge sums of money. The central banks have done a quick bodge job ‘combating’ inflation, but be sure that as soon as governments push for the ‘fight on inflation’ to be over, the rhetoric will change, inflation targets will increase and QE will be back. 

This will be good for gold and other hard assets, and pretty bad news for those paper ones. So for now, don’t worry about gold this month, or even the next, just ask yourselves: how on earth are governments going to get out of this one?