Late last year the world’s major developed market central banks performed a simple routine: a pause in monetary tightening, subsequently followed this year by a synchronised dovish pivot. Investors applauded, and equity markets took off on a four-month tear – interrupted only by the trade war escalation in April.
This was a little troubling to observe. The idea that this war of attrition between the US and China could end neatly was never foretold in the pages of game theory and history texts. But that is not what unnerved.
Unprecedented levels of global policy uncertainty have greatly diminished the capacity for monetary policymakers to generate growth. But even that is not so disturbing either.
The problem investors should fear is far more profound, and financial markets have yet to fully come to terms with it. The problem is that macro-economic theory has not served policy well. The implications of this have never been so concerning.
To begin with, the link between interest rates and savings and investment is overestimated, in econometric models as well as in theory. Compounding that, low inflation has been misread by central banks as a marker of sub-par output. Finally, the belief that monetary policy will be neutral in the long run – unless we think of the short run as lasting decades – has been blinding.
In light of this, for many decades developed market central banks allowed credit cycles to heat up and only reacted to them when they turned down – the GFC being the starkest example. Low inflation was the fig leaf used by central bankers to show that policy inaction was appropriate at low levels of interest, even when debt levels were soaring. This asymmetry has led yields to lower and lower levels.
All the borrowing induced by low interest rates has generated little by way of inflation or growth. This has prevented or limited the extent to which central banks can raise policy rates. High debt levels have essentially locked in low levels of interest rates and thereby threaten the theory of monetary policy neutrality.
Consider episodes of fast credit growth over the past couple of decades. What did the debt finance? In the US, in the years leading up to 2008, it was housing. More recently, Australians have invested in property; and in the US, corporates have engaged in equity buybacks. The spirits unleashed by low interest rates may have been animal, but they have not been entrepreneurial as much as speculative.
Claudio Borio, of the Bank for International Settlements, has developed these concepts and a hypothesis called “financial cycle drag” that has the potential to revolutionise the understanding of monetary policy. His insights are profound and rival the “secular stagnation” thesis, most notably proposed by Larry Summers.
The belief that central banks can improve the growth and inflation outlook effortlessly is an illusion.
The reality is that through their actions and inaction over past decades, central banks have constrained themselves to low interest rates and to a flawed policy framework.
The exposure of this illusion in financial markets is what we should all fear. The consequence will be that financial crises will not easily be resolved by central bank action, and risk appetite will then freefall for longer – causing untold damage to global markets.
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