Central Bank Inflation Targets…Be Careful What You Wish For

Did you ever ask yourself what this central bank obsession with inflation is really all about? After all, it is highly ironic that these erstwhile stewards of price stability have now perversely morphed into the frantic pursuit of currency destruction. This is because the current doctrine adopted by global central bankers is that growth comes from inflation; and without inflation there can be no growth. Therefore, as their new dogma dictates, inflation must be achieved at any cost.

One of the new strategies deployed by central bankers to raise prices is to push interest rates into negative territory. But negative interest rates are certainly not about paying consumers to take on new debt. And they aren't really so much about compelling banks to lend money by charging them to park fallow reserves at the central bank. Rather, the truth is negative interest rates are mostly about keeping insolvent governments afloat by constantly reducing debt service payments. In fact, there is currently about $7 trillion worth of global sovereign debt with yields that are less than zero.

Thanks to record low interest rates in the U.S. (although not yet negative), the Treasury spent just $223 billion (6%) of Federal revenue to service its publicly traded debt during 2015. However, if Treasury yields went back to where they were prior to the Great Recession of 2008, that figure would jump to about $700 billion, or 21% of all Federal revenue.

Since the U.S. is barely growing at record low rates, it would likely be a severe economic shock if debt service costs were to spike in such a manner. And achieving the Fed's 2% inflation target is exactly the type of thing that would the cause such a surge in borrowing costs. That's what makes the Fed's inflation quest all the more insane.

But the consequence of central bank "success" in reaching a 2% inflation target in Japan would be much more destructive than in the United States. Japan officially announced the move to negative interest rates on bank deposits on January 29th. Yields on sovereign debt, which were already negative going out seven years along the curve, subsequently went negative out to 10 years. As a result of these extremely favorable interest rates, the Japanese government currently pays about 15% of its revenue to service the debt. However, if interest rates were to increase back to 2%--the level seen before the Financial Crisis-Japan would be forced to pay a whopping 60% of its revenue for debt payments.

Japan has been mired in an economic morass for decades. The nation recently announced Q4 2015 GDP shrank at a 1.4% annualized rate. Indeed, Japan is flirting with its fifth recession in the last seven years and has suffered negative growth in two of the last three quarters. If debt costs were to surge from 15-60%, the Japanese economy would move from a perpetual recession to a devastating depression in short order.

It is a good bet that central banks will eventually be able to achieve their inflation targets-they have historically always been able to do so. They may resort to circumventing the banking system by directly purchasing newly issued government debt if ZIRP, NIRP and QE don't satisfied their inflation goals.

And this is why central banks are guaranteed to fail miserably in their effort to produce viable growth through inflation. Once inflation targets are reached they will have to begin winding down purchases of sovereign debt or risk pushing prices out of control. If not, it would lead to utter currency destruction, soaring yields on all fixed income assets and economic chaos. Therefore, they will be forced to switch from deflation fighters to inflation fighters.

But this change in monetary policy will come after these central bankers have so massively distorted the bond and equity markets in relation to the economy that it could cause both equity and bond prices to crash simultaneously. This is because investors will rush to front-run the offer to sell sovereign debt and equities from central banks. It is no coincidence that the S&P 500 began its topping process once QE ended in October 2014 and that the average stock had fallen 25% in January of this year after the Fed began to raise interest rates.

The real purpose of all the extraordinary and unprecedented measures taken by central banks over the past few years isn't about achieving an arbitrary inflation target. I don't believe the Fed, the European Central Bank or the Bank of Japan really believes 2% inflation is better for productivity and labor force growth than having no inflation at all. The reality is these central banks need an excuse to continue manipulating bond yields inexorably lower in order to accommodate soaring debt levels.

But in this endeavor there is no easy escape. The equity and bond markets have become absolute wards of central bankers and central banks cannot stop buying government debt without causing markets and economies to crash. Of course, they will eventually have to stop in order to avoid runaway inflation. That is the huge dilemma facing global central banks. And unfortunately, this means the real economic and market volatility is yet to come.