The answer:  all of the world’s central bankers.  In a surprise move on Friday, the Bank of Japan introduced a negative interest rate policy by charging a .1% fee on commercial banks for holding excess reserves.  The BOJ hopes this will encourage banks to make more loans to stimulate economic growth.   They indicated that they would push rates further into negative territory if needed to lower borrowing costs in order to achieve their inflation target of 2%.   Stock markets around the world rallied on the news, as Japan’s Nikkei 225 index rose 2.8%; China’s Shanghai composite rose 3.1%, Britain’s FTSE 100 rose 1.2%; France’s CAC 40 advanced 1.4%; Germany’s DAX climbed 1.3% and the U.S. markets gained over 2%.  Despite the late rally, U.S. stock indices posted their worst January in seven years.

What’s interesting to note is that the BOJ is not the first country to operate under a negative interest rate policy.  The European Central Bank (ECB), Sweden, Denmark and Switzerland are all charging banks to hold deposits.   By the end of 2015, one-third of the debt issued by euro zone governments had negative yields, meaning that investors who hold securities to maturity will not get all of their money back.  Banks have been reluctant to pass on the costs of negative interest rates to retail customers, but that may change if global economies do not improve.   The U.S. actually hiked interest rates back in mid-December of 2015 for the first time in nearly a decade, moving the Federal Funds rate to .25%.   That moved sparked an initial stock rally, but the plummet in oil prices and fears of a global slowing of growth have most major stock indices down by 5% or more in 2016.

So why do central bankers fear deflation so much?  Their main argument against deflation is that falling prices lead consumers to postpone purchases to take advantage of even lower future prices.  This collapse in demand causes prices to fall even further leading from deflation to eventual depression, as decreased spending lowers company sales/profits and increases unemployment.  This definition is in every Economics 101 textbook, but in my opinion tends to overly confuse correlation with causation.   Indeed, a recent study by Atkeson and Kehoe spanning 180 years for 17 countries found no relationship between deflation and depression.  You can find the study at this link: Atkeson/Kehoe Study on Deflation and Depression.  Deflation’s textbook definition is too rigid, and does not seem to realize that lower prices are good for consumers and can actually spur future growth.   The electronics industry has survived, and thrived, during a decades long run of continually lower prices for advanced TVs, audio and cell phones.   Apple has had no trouble selling expensive iPhones despite guaranteed lower prices for the same products just a year later.  Deflation increases consumer purchasing power, as the same dollar of currency now can buy more products and acts as an invisible raise for workers.

At the heart of this struggle between deflation and inflation is the attempt for government control of an uncontrollable global economy.  While deflation can certainly lead to economic hardship (Japan has been mired in a deflationary slump for decades), it is mainly a necessary process for any economy in order to temporarily realign prices to levels which more closely recognize what a society wants to be produced.   When governments intervene by manipulating the money supply,  interest rates and relative currency values, they distort the economic process and can exacerbate asset bubbles.   Governments also loathe deflation because they lose tax revenues.  Not only do they get less in sales tax receipts from the decline in product prices and consumer purchases, but they also miss out on income taxes from the invisible worker raises.  When workers get a 5% salary increase, that raise is directly taxable on their W2.   If deflation causes a 5% drop in prices, worker’s paychecks are now worth 5% more but not directly taxable.  For governments (like ours) that have already spent your future taxes, that’s a big problem.  Inflation, on the other hand, can be disastrous to citizens by wiping out the purchasing power of their income and savings.  Most global central bankers believe that “a little” inflation is a good thing, and target a long-run inflation rate of 2%.  But even 2% inflation, compounded over 35 years, would result in the doubling of consumer prices.  All else being equal, we would naturally like some things to rise in value –  our incomes, security values and our homes to name a few.   But the success of central bankers in threading the needle between deflation and inflation is questionable.   The deflationary slump in Japan and the runaway inflation of Argentina and Venezuela, not to mention the market collapses in 2001 and 2007, serve as current reminders of the failure of central bankers.

When the Federal Reserve was created in 1913, its defined role was to “conduct the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices”.   It is also supposed to “maintain the stability of the financial system and contain systemic risk that may arise in financial markets”.   Due primarily to the recent financial crises, the Fed has expanded it’s role in the financial markets with three rounds of “quantitative easing” (QE) which ultimately transformed the Fed into a government investment vehicle with an open-ended mandate to print money.  By continually buying financial assets from commercial banks to keep a lid on interest rates, the Fed’s balance sheet ballooned to nearly $4.5 trillion by the end of last year, up over 400% since 2007.    Across the globe, we are now seeing some kind of financial engineering from nearly every country in an effort to protect their economies.  Whether it’s negative interest rates, QE, currency devaluation or some other measure, these artificial economic boosters are most likely going to end badly for many countries.  In a globally interconnected economy, the financial manipulations in one country are met by offsetting moves in others, with the relative benefits then being minimized or negated.  The end result is that the same structural problems that existed before are still present, only with added levels of financial leverage.  I have an 8th grade son who is an excellent basketball player, and it would increase his effectiveness if I held him back one year in school so that he could play against younger players on a going forward basis.  But if everyone decided to hold their son’s back one year, his advantage would be wiped out and all the boys would just end up wasting their time by re-taking 8th grade.

In summary, global markets are driven primarily by supply and demand.  Prices for labor, goods and services are the markets way of allocating scarce resources, and when distortions to these processes are injected into the mix we can end up with disastrous results.  Governments and central banks make attempts to smooth out the cycles of boom and bust, but their attempts to tame the markets is only temporary.   We have built massive levees to control the flow of many great rivers, and they always work well – until they break.  The current financial engineering by global central bankers is bound to produce some short-term winners and losers, and the lesson for investors is to always keep their focus long-term.  Diversified portfolios containing equities, fixed income, alternatives and cash are the best way to participate in market growth while minimizing portfolio risk.