Are we heading for mutually assured monetary destruction?

Last week, the BBC put out a programme detailing most people’s worst geopolitical nightmare – a “hot war” in Europe.

You might have seen it. The idea was that former generals, diplomats and civil servants were asked to respond to a series of situations based around a Russian attempt to invade Latvia.

The scariest bit came at the end, when they were asked to respond to a nuclear missile being launched at a major UK city.

Their response (and maybe this shows that I think about monetary policy too much, I don’t know) couldn’t help but remind me of how central bankers do their jobs…

Central banks are at ‘Defcon 3’

An enemy launches a nuclear strike on one of your biggest population centres. If you’re a child of the 80s or any time before that, you know the drill. Everyone presses their big red buttons and it’s a case of Planet of the Apes, here we come.

But maybe not. In last week’s BBC drama-docu-reality TV show, simulating such a situation, most (though not all) of the panellists decided against retaliating. In their view, the point of a nuclear deterrent is to deter, not to cause mutual obliteration. So actually launching a response would be pointless.

It’s an – eh – “interesting” argument (I do hope Putin wasn’t watching).

But it makes the point that perceptions can matter as much as actions, something that certainly applies to investing – and central banking in particular.

You see, central bankers are a bit like the generals in the BBC documentary. They have lots of tools at their disposal – everything from money printing to negative interest rates. But the effectiveness of these tools often boils down to whether or not the market believes you are going to use them or not.

And that’s not always that straightforward. For example, European Central Bank (ECB) boss Mario Draghi, US Federal Reserve head Janet Yellen and Bank of England governor Mark Carney can’t just go it alone. They all have to get the approval of a council.

For Draghi in particular, it’s tricky. He has to deal with several heads of national central banks who are convinced that any money printing will lead to inflation. They will therefore veto anything they think is too radical.

And while central bankers are supposed to be independent, they also have at least to be aware of the wider political context. We’re pretty sure that Draghi consults with Brussels and leaders like Angela Merkel before making his final decision. Similarly, Carney knows that he owes his job to George Osborne.

All this means that central bankers have to manage expectations as much as actually “do stuff”. The idea is that if the markets expect a course of action then it will price something accordingly, and give you the result you want without actually having to do anything.

The classic example here was Draghi’s pledge to do “whatever it takes” to save the euro in the summer of 2012. It took him 18 months to convince Europe’s leaders to let him print money. But the promise itself immediately stopped investors from pulling money out of the euro area.

The central banker who cried wolf

The trouble with this strategy of course, is that if you keep doing it, eventually people expect you to follow through. Draghi disappointed a lot of people when he decided not to launch another round of quantitative easing at the end of last year, particularly as the European recovery continues to be slow.

Since then, Draghi has dropped bigger hints that he’s planning something radical in the March meeting. In January he widened the range of collateral that the ECB would be willing to buy. He said that there would be “no limits” to action taken to boost eurozone inflation. And he recently repeated this, stating that “the risks of acting too late outweigh the risks of acting too early”.

Now you could dismiss this as another bluff. Trouble is, that’s not really an option anymore.

You see, expectations management works both ways. The Bank of Japan managed to startle complacent investors when it turned interest rates negative last month, because it had already explicitly said that it wouldn’t do it. That meant they got far more “bang” from what was in fact a less radical move than it at first seemed.

So if Draghi wants to maintain momentum in the currency wars, he really needs to follow through here. As Jonathan Loynes of Capital Economics points out, the euro has risen by 4% since November.

One measure Draghi could take is to launch another wave of QE, expanding the amount of assets that the ECB buys each month. Meanwhile, he could also push interest rates deeper into negative territory. We’ve already seen this happen in Sweden, Denmark and Switzerland, which have negative rates of -0.35%, -0.65% and -0.75% respectively.

It’s all rather self-destructive in the long run, but it would certainly goose stock markets in the meantime (one reason why we’d stick with eurozone stocks).

This is all woeful news for anyone with savings of course. And as my colleague John Stepek has pointed out, it’s not hard to see this “war on cash” coming to the UK if the economy (or housing market) takes a sudden downturn.

We’ll be writing a lot more about this in the next issue of MoneyWeek magazine. Meanwhile you can read more about this in my colleague Tim Price’s book, The War on Cash.