investment viewpoints

Central banks need to respond to populism

Central banks need to respond to populism
Salman Ahmed, PhD - Chief Investment Strategist

Salman Ahmed, PhD

Chief Investment Strategist

Monetary policy is ripe for a paradigm shift. Developed market central banks are underestimating the impact populism could have if monetary policy does not take into account income inequality, and fast. Monetary Policy frameworks need to incorporate a "Behavioural Macroeconomics" based approach that directly takes into account the emotions and psychology of economic agents. 

Despite three decades of unprecedented global growth, rising consciousness around inequality is reshaping the economic and investment landscape. The rich have been getting richer almost everywhere over the last 35 years, but, generally speaking, neither the middle class nor the bottom half have fared well in major developed or emerging economies. Globalization and technology are partly to blame for unevenly rewarding skilled labor and changing the interplay between capital and labor returns. But the debate around central bank’s role in exacerbating inequalities is certainly getting more attention – and rightly so.

Consumer price inflation has been the key macro variable driving monetary policy since the early 1990s and is now the framework for many central banks across the world.  However, since the 2008 financial crisis, monetary policy has expanded beyond simply setting interest rates as the policy response focused on protecting economies from depression-type conditions.

It is now well accepted that Quantitative easing (QE), for example, has worked through a portfolio rebalancing effect as central banks tried to reignite ‘animal spirits’, incentivizing people to hold riskier assets. Key architects of QE, such as Ben Bernanke, have downplayed the impact such aggressive monetary policy had on inequality.

David McWilliams argued in the Financial Times recently that the Federal Reserve’s effort to stave off a depression sowed the seeds of generational revolt between the baby boomers and millennials. 

Rising inequality has been an important factor in the sharp upturn in US and European populism. The ascent of the “Trump phenomenon” now appears more than an aberration as it spreads to the hard left and strengthens. In Europe, the ascent of populism in Italy is clear cut, whilst, in Germany, the far-right Alternative for Germany party has enjoyed a resurgence following the 2015 migration policy change.  In France, images of ‘gilets jaunes’ protests have been sobering.

These shifts will likely have long-term implications for western political and economic order, which central banks are not immune from.

For example, the Fed’s quick and profound pivot during the first quarter of 2019 came against a backdrop of intense presidential pressure, despite the Fed protesting its independence. Fed Chair Jerome Powell down-played the role of equity markets in determining financial conditions in December, but by March, the rhetoric completely reversed and the Fed made a significant leap towards employing consumer price-level targeting. This is the most rapid and profound shift we have seen outside recession years.

In today’s populist era, central bank policy in liberal democracies needs to incorporate consideration of inequality-driven anger because it will likely be a strong influence on future political realities. In financial markets, the case for behavioral finance is well understood and central banks can learn from this approach to incorporate Behavioral Macroeconomics into their reaction functions.

This is particularly important in Europe where there is complete aversion to meaningfully altering fiscal policy, even though tax policy plays a critical role in ‘correcting’ unfair income distribution effects resulting from monetary policy.

A major rethink of the European Central Bank’s (ECB) reaction function is urgently required. The bank needs a more focused, credible and visible commitment towards fulfilling its 2% inflation target. It also urgently needs a broader set of policy tools such as targeted large-scale credit deployment to SMEs and mid/low-income groups despite potential risk of capital misallocation. This is especially true if the likelihood of another economic downturn continues to rise. Indeed, milder versions of money-financed fiscal policy, such as that seen during wartimes, needs to be put on the table as a serious option.

It is important to remember that if a serious downturn were to hit the single currency area, the consequent political implications would be more forcefully charged by the current rise in populism. The nature of democratically-elected government implies that if technocratic institutions such as the ECB continue to interpret their mandates in a narrow way, they may inadvertently add to the populist pressure.

Indeed, if this plays out, as we are seeing in Italy, it could have powerful knock-on effects on the shape and scope of the central bank’s mandate going forward, if not the future of the union itself.

All in all, avoiding a recession is an economic and political imperative as current paradigms are under serious threat of being permanently dislodged. The time has come to rethink central banks’ reaction function to reflect Behavioral Macroeconomics.

important information.

For professional investor use only
This document has been issued by Lombard Odier Funds (Europe) S.A. a Luxembourg based public limited company (SA), having its registered office at 291, route d’Arlon, L-1150 Luxembourg, authorized and regulated by the CSSF as a Management Company within the meaning of EU Directive 2009/65/EC, as amended.
Lombard Odier Investment Managers (“LOIM”) is a trade name.
This document is provided for informational purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This document does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipients exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. The contents of this document are intended for persons who are sophisticated investment professionals and who are either authorised or regulated to operate in the financial markets or persons who have been vetted by LOIM as having the expertise, experience and knowledge of the investment matters set out in this document and in respect of whom LOIM has received an assurance that they are capable of making their own investment decisions and understanding the risks involved in making investments of the type included in this document or other persons that LOIM has expressly confirmed as being appropriate recipients of this document. If you are not a person falling within the above categories you are kindly asked to either return this document to LOIM or to destroy it and are expressly warned that you must not rely upon its contents or have regard to any of the matters set out in this document in relation to investment matters and must not transmit this document to any other person. This document contains the opinions of LOIM, as at the date of issue. The information and analysis contained herein are based on sources believed to be reliable. However, LOIM does not guarantee the timeliness, accuracy, or completeness of the information contained in this document, nor does it accept any liability for any loss or damage resulting from its use. All information and opinions as well as the prices indicated may change without notice. Neither this document nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Funds (Europe) S.A prior consent.
©2019 Lombard Odier IM. All rights reserved