The Fed is behind the curve, and happy to stay there

There is a widespread view that the Federal Reserve will have to raise interest rates at a steady pace this year, because it cannot afford to fall behind the curve.

I would argue that it has already fallen behind the curve and has no choice but to remain there. And it is not the only one in this situation. All major central banks are playing the same game; they have no choice.

People still believe, largely because that’s what central bankers and politicians want them to do, that central banks worry about defending inflation. But if you look at real interest rates across the world, they don’t.

Let’s take the Fed. The current interest rate, after last week’s hike, is between 0.75% and 1%. And inflation? Consumer price inflation was 2.7% in February, rising from 2.5% in January. Ah, but that’s because oil prices have increased, some say; nothing the Fed can do about that.

Fine, let’s look at the Fed’s preferred inflation measure, which strips out the “volatile” food and energy prices. Core inflation was 2.2% in February, which was the 15th month in a row that core CPI remained between 2.1% and 2.3%.

Of course, we’re not going to get here in the whole debate of whose inflation is this, anyway. We know that for many people, these percentages seem too small compared with their actual experience.

Judging by these figures alone, the Fed’s interest rate should not be 1%. It should be more than 2%. So why does the Fed impose this real negative interest rate and why can’t it end the financial repression it’s been submitting savers to since the 2007-2009 financial crisis?

The answer is in the other type of inflation, which the Fed chooses to ignore completely and which has been much worse: asset price inflation. The major stock indices have hit record after record and in many parts of the world, house prices have breached previous records, as the money created by central banks chases investments.

I suspect central banks knew all along that their quantitative easing programmes will not push capital into productive investment but will, instead, inflate asset prices. In fact, that was the hope all along.

Expensive assets in times of financial repression when cash holders are punished make much better collateral than cheap ones. So new debt can be created by banks without too much fear.

As for the old debt, the only chance of it being paid is if it is inflated away. Debt forgiveness is not an option, because credit default swaps, essentially insurance against default, would kick in the minute such a path is taken.

There is no way any central bank head would admit this out loud. But equally, there is no way they will “normalize” monetary policy any time soon. Central banks are, and will remain, firmly behind the curve. Let’s hope the curve doesn’t steepen too fast on them.