Macro

Central banks (including ours) are faced with two choices: “rescue” the world from its economic slowdown; or stand aside and let the inevitable correction take place.

In reducing the cash rate to a record low of 1.25 per cent, Reserve Bank of Australia (RBA) governor Philip Lowe has joined his global peers in falling for the paradox of monetary policy perfection. This global obsession by the highly intelligent, increasingly interventionist and ultimately human central bankers has dominated financial markets in the 12 years since the global financial crisis (GFC).

The record low interest rate environment and unprecedented liquidity from quantitative easing has inflated asset prices, particularly equities and property.

Will they have the self-control to let financial markets correct, or will they continue in their pursuit of monetary policy perfection?

The S&P 500 index has climbed 307 per cent since the GFC and the ASX All Ordinaries index has increased by 110 per cent. This rally in share prices is inconsistent with the underlying economic story. For example, US corporate debt has increased 65 per cent with interest costs jumping only 23 per cent. Despite this increased leverage at minimal costs, corporate profits have only moved up 29 per cent. Similarly, the surge in east-coast Australian real estate prices beggars belief when rental yield is considered.

The creation of this policy environment was driven by necessity; the GFC required a strong response.

Yet despite the risks, the same toolkit has been deployed in less justifiable circumstances, such as economic stagnation. The removal of an appropriate hurdle rate has simultaneously led to the gross mispricing of risk within the financial system and the exhaustion of central banks’ arsenal. The unintended consequences may take us full circle – remember that the GFC was caused by a property bubble.

Lowe cited rising unemployment and falling property prices as the major concerns underpinning his move to cut the cash rate. In doing so, the RBA has significantly reduced its ability to stimulate the economy if conditions are negatively impacted by material and unexpected events, such as an abrupt end to Chinese stimulus.

Stubbornly, Lowe and other central bankers may take solace in the fact they are steering their economies towards their target inflation rates, but their relevance is diminishing under the shadow of asset bubbles.

Rescue or stand aside

Australia’s central bank, like that of all advanced economies, is faced with two choices: “rescue” the world from its economic slowdown; or stand aside and let the inevitable correction take place.

The axiom that highlights the dominance of central banks in financial markets – “you can’t fight the Fed” – has never been truer. Central banks have determined the world’s financial fate for more than a decade. Will they now have the self-control and humility to let financial markets correct, or will they continue in their interventionist agenda in the pursuit of monetary policy perfection?

The importance of this choice cannot be overstated.

On the one hand, it could lead to asset bubbles driven by zero or even negative interest rates and further quantitative easing in major economies. The resulting burst would be unprecedented.

On the other hand, central banks, led by the US Federal Reserve, could normalise the monetary policy environment and begin the correction that would mirror the reality of the business and market cycle. The latter course of action would require modesty, resilience and an outright abandonment of the paradox of perfection.

Matthew Haupt is a Lead Portfolio Manager with Wilson Asset Management , responsible for WAM Leaders (ASX: WLE).



Comments

Please sign in to comment on this wire.

Ian

Not a chance that Central Bankers will stand by and do nothing as the economic environment worsens. I'm sure we'll see negative interest rates and lot more "unthinkable" policies over the next decade, even in Australia! It seems the standard response these days is "to Hell with the savers, we've got to save the borrowers", but surely it's going to get increasingly difficult to convince people to borrow ever greater amounts?

Daniel Verblun

This article ignores the macro situation completely and uses history (thirty years ago and further back) as a guide to the future. It is not only developed economies that are facing 'stagnation'; inflation and wage growth are moderating fast in developing countries too. Technology that automates previously human jobs, together with huge growth in the population fighting for the remaining tasks, means that everything is cheaper (except land in global super city centres: Melbourne and Sydney are luckily to be included in the rarefied pack). Your article fails to address why real estate in other Australian states has failed to keep up - because Melbourne and Sydney reflect fundamentals. Yields of listed equities and fixed estates in such cities are correctly priced as they provide reliable income in the face of huge disruption and deflationary forces. If a company is still listed today it means it is either tech or it defensive enough to have survived the last twenty five years of massive disruption and deflationary forces. Also, central banks do not control interest rates as they drop, and merely drop them in response to correct market pricing. They are basically like a lolly-pop man. The pedestrian light goes green, and they then stand in the road to confirm it's safe for the school kids to walk across. In today's world, central banks can only influence rates when they are making policy errors (ie on the way up - for example the Fed error late last year which sparked as a reaction on the 24th Dec 2018 the largest single day drop in equity markets since 1931), and of course banks gleefully follow (main example of this is GFC which was caused by adjustable rate mortgages which under-employed consumers with stagnated wages simply couldn't afford) but inevitably central bankers have to reverse course on their policy errors - we will see easing in the second half of the year in the US and particularly in Australia, where rates have been too tight since at least 2005 - this is because interest rates in Australia have been set in response to aggregate GDP growth (which benefits the competitive advantage of mainly foreign owned mining exporters; and population growth) and has not been set according to per capita GDP growth and domestic demand.