NEW YORK (Real Money) -- There are nascent signs of a profound shift in ideology by global central bankers regarding the application of monetary policy. Traders and investors alike should be watchful, as this could have a substantial impact on all asset classes in the near future. Yet neither the markets nor the financial media have recognized this phenomenon.
When modern central banking was established with the creation of the U.S.
in 1913, it was partly a reaction to a series of business boom and bust cycles following the Civil War and the emergence of the Industrial Revolution, culminating with the banking crisis of 1907. The political rationale for creating the Federal Reserve was to provide countercyclical intervention to thwart economic activity that resulted in either inflation or deflation, thus mitigating the business cycle. As logical as it sounds, the idea of intervention has been contested by large segments of academia dedicated to the study of economics and political economy.
These concerns have been raised by academics studying and mapping cycles of all kinds, both naturally occurring and in manmade institutions. The principal concern has been that business and economic cycles, as well as other social and civilization cycles, are a natural part of the human condition, and attempting to mitigate them could easily cause the duration and amplitude of the cycles to increase rather than decrease.
Mitigating the effects of an economic or business cycle contraction with stimulus would only postpone the immediate severity of the contraction, while simultaneously becoming a contributing factor to an even more distorted market in the future that would require even more stimulus to prevent an even greater contraction. This process would continue until stimulus was no longer effective and the markets would clear naturally, and spectacularly.
The risk of this happening was the principal factor in the Federal Reserve adhering to a reactive, rather than preventive, policy. This, however, is not a part of the Fed's legal mandate, and each Fed chair is left to determine what the difference is.
Although the world's central banks have different operational procedures and mandates, they have all been designed following the U.S. Fed as a model and they abide by this broad mandate of reactive intervention. The world's principal central banks -- the Fed, Bank of England, Bank of Japan, and European Central Bank -- are beginning to express a recognition that their policies since 2008 (the BOJ since the mid-1990s) may have been preventive and, as a result, magnified the real economic and business cycle distortions.
As a result, they may now begin the slow and steady process of reverting to a reactive stance and allow the markets and economies to clear excesses of the past several years. Wednesday's nominal move by the Fed may be considered by investors as the first step in that process in the U.S. If so, traders should anticipate future intervention after a crisis and losses have been realized, not before.
The monetary safety net is being replaced by an ambulance.
Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.