Its hard to disagree with this article from MoneyWeek that central banking has been a complete disaster for mankind. But to put all the blame at the feet of central banking would be wrong. Politicians, the media and of course our own ignorance has played a major hand in where we find the global economy. The days of CBs focusing on taming inflation via interest rates is long gone. Instead we get endless bubbles, and now the biggest bubble of all the debt bubble and a big unavoidable shit pile up ahead. 

Central bankers are throwing caution to the winds

There’s a revolution going on in the central banking world.

When the cult of independent central bankers took hold, their main enemy was inflation. They all had to keep inflation rising at a gentle pace of around 2% a year.

They didn’t care about asset price inflation. The price of a house could rocket as much as it liked. And they were quite relaxed about the soaring price of energy as long as this was offset by a drop in the price of music players, for example.

All in all, they managed to stick to the inflation target pretty well. Meanwhile the economy still overheated massively, then collapsed in on itself under the weight of all the debt everyone had taken on.

CBs new recipie for success. It doesn’t involve worrying about inflation, thats just for the little people.

That approach clearly didn’t work. So what’s the new recipe for success?

The Federal Reserve in America has thrown caution over inflation to the winds. It is now emphasising employment over price changes. The Fed has become even more aggressive in its monetary policy, even as the US economy seems to be healthier than it has been in a long time.

In the UK, the Bank of England governor-in-waiting, Mark Carney, says he’s a fan of NGDP targeting. You can read more about this from my colleague Seán Keyes here: Should we replace Mervyn King with a robot? In short, it means you target a certain level of nominal economic growth. If that means tolerating inflation at 5%, while ‘real’ growth is at 0%, then so be it. In other words, it’s a way to go soft on inflation without breaking your rules.

And in Japan, the new party in power has sworn to stop deflation. The Bank of Japan may end up with a new inflation target of 2%, double its current target.

In short, central banks have decided that inflation doesn’t matter any more. Fretting about this target is holding them back from taking the decisive action needed to resuscitate our ailing economies. 2013 is going to be all about taking monetary policy to the max.

We sense disaster looming.

Central banks have a bad record – why trust them now?

Central banking might just work, if it was genuinely independent. If you had central bankers who were willing to do the whole ‘counter-cyclical’ thing, we might have a more stable economy. In other words, if central banks were willing to raise interest rates to temper booms, rather than just slash them to alleviate busts, then they might do some good.

But this is never going to happen. Central banks argue that it’s impossible to see asset bubbles inflating. This is nonsense. The fact is that they don’t care about bubbles.

All that matters to them is that the economy keeps chugging forwards. It doesn’t matter whether it’s chugging towards the promised land or towards a cliff edge – all growth is good growth. So they will never act to rein in a boom, regardless of whether it’s ‘healthy’ or not.

This is because central banks are political institutions. They are not independent. And as long as you understand this, then it’s easy to see why we’re trapped in this self-destructive cycle of bubble-blowing.

Politicians will always pursue ‘boom and bust’ policies because they always think they’ll get out on time. Voters love a boom. Taking the punch bowl away during the boom time is not the way to win votes. And by the time the bust arrives, it’ll be someone else’s problem, with any luck.

This central bank bias in favour of ‘easy’ money lies at the heart of all the bubbles we’ve seen in recent decades. The tech bubble inflated, then burst. Interest rates were slashed. The property bubble inflated, then burst. Interest rates were cut to near-zero, and central banks started buying government bonds. So we now have a bubble in government debt.

There is one thing that is more toxic for bond prices than anything else – inflation. And right on cue, across the world, central banks are falling over themselves to abandon inflation targeting.

Is there a method in their madness? Or are they just pursuing growth at any cost? Past performance is no guide to the future, we’re always told. But I think anyone who believes that central bankers are going to get it right this time is being almost deliberately naïve.

So what can you do about it? A bond market blow-up would be nothing short of disastrous for most asset classes. We can’t know when it’s going to happen. But it’s one good reason to make sure you have a well-diversified portfolio.

We’ve been knocking about some ideas for setting up a long-term, cheap-to-run, core ‘retirement’ portfolio at MoneyWeek recently. We’re looking for something that allows you to sleep at night without sacrificing a big chunk of performance.

We’ll have more details on this in the New Year, but it’s certainly made me think a lot about how investors can survive and even make money with this potential disaster looming in the background.

Loosely speaking, I’d suggest having some money in cheap stocks (Japan in particular – see here for more), very little – if any – money in bonds (except perhaps index-linkers), some gold, and a decent amount of cash. The cash is there to give you the opportunity to snap up cheap assets if and when the bubble finally bursts.

Some interesting quotes relevant to Central Banking

“It is no coincidence that the century of total war coincided with the century of central banking.”

Ron Paul

“the last duty of a central banker is to tell the public the truth.”
         – Alan Blinder (former Fed Reserve Board Vice Chairman)

Source: MoneyWeek