“One job! Just one job….”
To manage the economy to a target rate of 2% inflation. Clearly scarred by the criticism of the Bank of England having rings run around it for more than two years as inflation ran riot, Governor Andrew Bailey has ordered an independent review of its forecasting processes. Appointed to lead the review is Ben Bernanke, former Chairman of the US Federal Reserve.

Bailey said: “Dr Bernanke is a renowned and award-winning economist whose distinguished career makes him the ideal person to lead this review. The UK economy has faced a series of unprecedented and unpredictable shocks. The review will allow us to take a step back and reflect on where our processes need to adapt to a world in which we increasingly face significant uncertainty.”

Having someone else mark your homework is good discipline, whatever the circumstances. It is quite right that organisations including regulators need to learn from experience particularly when real outcomes have diverged markedly from theoretical expectations. Flexibility and remaining adaptable to changing circumstances in a significantly uncertain world are important. That the UK economy has been through a torrid time is undeniable. GDP shrinking by close to 10% in 2020 and recovering (rather than growing) by 7.6% in 2021: those magnitudes of volatility in economic activity in a mature developed system are genuinely extraordinary. But “unprecedented and unpredictable shocks”? That assertion needs both challenging and dismantling. It is almost as though Bailey is saying that in hindsight things went wrong that should not, but in exculpating the Bank because the shocks were “unprecedented and unpredictable”, the lack of foresight was not its fault.
“Unprecedented and unpredictable shocks”: disabusing a faulty premise at the outset.
The two global exogenous shocks being referred to are clearly the pandemic and the Russian invasion of Ukraine. Neither pandemic nor war is unprecedented. Both have happened before and more than once. It is not even as though their overlapping is unprecedented: albeit in the reverse order of 2020-2023 events, the First World War was in its closing stages when Spanish Flu was first identified in February 1918 and persisted into early 1920, killing an estimated 25-50 million people.

Covid was unpredictable (a ‘Black Swan’ event) but a major viral or bacterial outbreak was not unexpected: think of the alarms over H1N1, SARS, Ebola and others in the past 20 years. However, mitigant strategies which in the event were ignored or discarded were nevertheless in place to deal with a pandemic. From an economic perspective what was underestimated and misunderstood was the significant impact of the severe disruption arising out of impulsive strategies shared by many governments confining their population to home and the knock-on effects to highly sensitive global supply chains, while at the same time suppressing domestic demand down almost to basic necessities (the caricature trinity of household staples: pasta, tinned chopped tomatoes and loo paper). In economists’ terms, both the supply and demand sides of the economy were significantly disrupted simultaneously; that too is not unprecedented although it is highly unusual outside wartime.

On which subject, a major international armed conflict and the use of sanctions either to deter or punish are certainly not unprecedented; nor was this situation unpredictable (a ‘Black Elephant’). Russia’s invasion of Ukraine was predicted, and had been for months if not years, backed by ample intelligence (and predicated by Putin having threatened western economic dislocation by weaponizing gas markets and then doing so six months ahead of the invasion); it was far less a question of if it would happen than how it would be prosecuted and when. That an invasion was discounted by most as being somewhere on the spectrum of unlikely-to-improbable-to-impossible because it was deemed irrational is an entirely different matter. The shock and market volatility when it occurred were a function of the consensus false logic that because it should not happen, therefore it would not happen.

“The UK economy has faced a series….”. The UK is Bailey’s specific responsibility. The phraseology implies (or at least allows the inference) that the UK’s experience was unique. It was not. It was a shared experience, to a greater or lesser extent common across most of the world. Where the UK experience is different is the extent to which the subsequent inflation has proved more difficult to control than most of our major competitors have found.

Where the Bank certainly does need help is in understanding three particular aspects: 1) why its estimates were wrong by more than 100% during the upward inflation trajectory; 2) why UK inflation has proved more stubborn on the reverse slope of the hump than other G7 countries; and 3) to what extent the Bank’s policies themselves were responsible for helping catalyse an inflation rate which peaked higher than most.

A respected academic economist, no doubt Bernanke’s investigation will shed light on the shortcomings of the Bank’s econometric models and make appropriate recommendations. As to what idiosyncratic forces were at work to generate greater amplitude to UK inflation as well as longer duration, presumably he will be paying special attention to government policy on domestic and business energy pricing mechanisms (the cap, and all its shortcomings) and the extent to which experts (mis)understood the consequences; the other major area of national focus is the UK labour market and wage inflation.
Bernanke: marking the Bank’s homework; he wrote the original textbook!
But it is on the linked subjects of labour and Bank of England monetary policy that Bernanke has a substantial conflict of interest. He wrote the textbook. Half a generation removed, he is in fact reviewing the consequences of his own handiwork.

Bernanke was head of the Federal Reserve (Fed) between 2006 and 2014; he was in the eye of the storm of the Great Financial Crisis; he was the progenitor of Quantitative Easing (QE) and the modern monetary policy deployed by most western central banks ever since. When he devised QE as a defibrillator to reboot the financial system, he probably had little idea that successive central bankers would instead reinvent and abuse his brainchild for longer-term economic stimulus. They made it an addictive economic drug. In which vein (excusing the pun), he saw the first ‘taper tantrum’ in 2013 as the Fed attempted to withdraw QE when bond markets were unprepared for it; the result was financial cold turkey as markets shuddered in an adverse reaction.

In his tenure he faced accusations of being ‘asleep at the wheel’ as the stars of light-touch regulatory policy, an unstable US housing market and the almost reckless development and all-pervading application of immensely complex (and little understood) derivative financial instruments all aligned to create the perfect storm of near financial melt-down. He certainly has a rich history of experience from which to draw!

But in his investigation at the Bank for the 2020-2023 period, his baby, QE, and its deployment are under the microscope. Faced with economic paralysis as populations were locked down in the pandemic, QE was used ferociously and prodigiously from March 2020 on both sides of the Atlantic as central banks coordinated to hose liquidity into the markets in conjunction with the splurge of central governments’ various fiscal life raft policies (state aid for key sensitive national industries, employment furlough programmes in the UK and Europe, business support loan schemes; ‘helicopter money’ programmes such as Rishi Sunak’s eat-out-with-a-tenner-a-head-as-often-as-you-like bribe etc).
Ignorance, intransigence or arrogance?

If the markets too underestimated the magnitude of the stimulatory effects of the concentrated over-supply of money and liquidity, they were well ahead of the central banks in seeing inflation as a potential and enduring risk because of it. Bond yields were perceptibly rising from late 2020/early 2021 while central bank policy makers were determinedly sticking to the common narrative that any inflationary pressures were likely to be limited and transitory (i.e. ‘nothing to see here, move on’). It would be a year before the Bank of England capitulated and raised interest rates from virtually zero in December 2021 (this week’s was the 14th consecutive rise); another three months after that before the Fed followed, and four months again until the ECB rid itself of negative rates in July 2022. What Bernanke needs to address is whether the central banks including the Bank of England maintained that “we’re not budging” line because their models predicted a benign, containable outcome (i.e. they were wrong), or whether it was because they remained arrogantly convinced that central banks had “controlled inflation” as Bailey’s predecessor Mark Carney declared in an FT seminar well before the pandemic (the ‘Masters of the Universe’ complex we have discussed before) and it would be summarily brought to heel now. In the Bank of England’s case, a critique is required as to why having been first away from the traps among the reserve currency central banks, its Monetary Policy Committee was subsequently less aggressive in forcing Quantitative Tightening (QT) than its peers.

To understand QT requires a no-holds barred critique of its predecessor, QE
Over 15 years, QE has had an insidious effect with three main themes:
  1. Real earnings erosion: labour markets have their own national structures built around national employment law, pensions, welfare systems, taxation etc. Through ultra-low interest rates and easy access to cheap credit, the creation of the zombie economy promulgated significant corrosive inefficiencies: cumulative surpluses of unproductive capital and labour leading to declining productivity and below-par growth rates thanks to an increasing economic dependency culture based on central bank support. Tied in with more than half a decade in the early 2010s of public sector wage restraint (‘austerity’), low productivity in the private sector stoked a prolonged period of falling real earnings. The advent of the inflationary cost-of-living crisis has provided the opportunity for public sector unrest in the demand for higher wages and the unions’ slogan of ‘ten years’ catching up’. Low levels of unemployment in a stagflationary economy (another symptom of low productivity) created an environment for steep upward pressure in private sector wages. The tightness of the overall labour market post-pandemic was exacerbated by a substantial proportion of the over-50s working age cohort absenting itself, something which left the Governor publicly bewildered.
  2. Political corrosion: Bill Dudley, a past Chairman of the Federal Bank of New York and a former colleague of Bernanke’s at the Federal Reserve, was the first to warn a decade ago of the unintended political consequences of QE. He forecast that the combination of asset price inflation resulting directly from QE and the indirect consequence giving rise to falling real earnings would between them create significant social and financial division between the ‘haves’ and the ‘have-nots’. It was a theme reiterated more than half a decade later in the UK by both Theresa May and Philip Hammond in their public criticism of the Bank of England when they were respectively Prime Minister and Chancellor. Dudley’s thesis was that eventually there would be a reckoning both politically and economically: the former in political polarisation and rising populism, the latter most likely to be evident in a concentrated and compressed period of economic strain which could have inflationary consequences. He was proved right on both counts.
  3. The debt explosion: not specifically linked with UK inflation (but still every bit as relevant to today’s investment circumstances) extended ultra-loose monetary policy underpinned by the central bank backstops, governments over a long period had few pressures to maintain fiscal prudence. The result has been the relentlessly rising nominal levels of debt. In previous columns we have discussed in detail the strain evident in the recent US debt ceiling stand-off in US Congress. A function of the tightness of the political maths, the eventual solution was minor tweaks to US government expenditure and a modest upward revision to the debt ceiling. As US government debt increases remorselessly, now to $32.3 trillion in June, $800bn higher than in May, this week rating agency Fitch has downgraded US government bonds from a AAA rating to AA+, pushing up the cost of servicing the national debt (crudely the rating has gone from “safe as Fort Knox”, to “probably still as safe but best check the burglar alarm, just in case”). It is doubtful that in the absence of QE, any government would have been allowed to run up debt more than the size of its GDP let alone wilfully to keep increasing it beyond (the US is over 130% debt/GDP; the UK is 100%). History will determine whether QE returns as an active instrument of loose monetary policy or whether it is already writing its own epitaph.
Bernanke’s will be a fascinating exercise, even provoking some personal soul searching of his own. Unlike most public enquiries which take years, hopefully this semi-private one for the Bank of England will be comprehensive, dispassionate (despite his pivotal role in shaping so much of modern monetary policy) and quick. It needs to be because the economy is dynamic, not constant. It is no easy task being a central banker, but when you get it wrong, and having admitted as much (a very positive first step), fixing it fast and convincingly is important to restoring trust and leadership.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

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