Sparring with Central Banks

January 31, 2012

Just one look at the whoosh higher in global markets in January and you’d be forgiven smug faith in the hoary old market adage of “Don’t fight the Fed” — or to update the phrase less pithily for the modern, globalised marketplace: “Don’t fight the world’s central banks”. (or “Don’t Battle the Banks”, maybe?)

In tandem with this month’s Federal Reserve forecast of near-zero U.S. official interest rates for the next two years, the European Central Bank provided its banking sector nearly half a trillion euros of cheap 3-year loans in late December (and may do almost as much again on Feb 29). Add to that ongoing bouts of money printing by the Bank of England, Swiss National Bank, Bank of Japan and more than 40 expected acts of monetary easing by central banks around the world in the first half of this year and that’s a lot of additional central bank support behind the market rebound.¬† So is betting against this firepower a mug’s game? Well, some investors caution against the chance that the Banks are firing duds.

According to giant bond fund manager Pimco, the post-credit crisis process of household, corporate and sovereign deleveraging is so intense and loaded with risk that central banks may just be keeping up with events and even then are doing so at very different speeds. What’s more the solution to the problem is not a monetary one anyway and all they can do is ease the pain.

Low interest rates and liquidity schemes can’t solve what ails the developed world. Societies must accept that in order to alter their current perilous course they must undergo great change, moving away from entitlements to which they have become accustomed. The alternative is weak economic growth, a loss of competitiveness and negative external balances — a loss of face and place in the global hierarchy.

As if to reinforce the underlying point that the developed world faces a protracted reform period that tests political, economic and social priorities, credit rating firm Standard & Poors’ — not the most popular company in corridors of power over the past year — warned on Tuesday¬† that it may downgrade the debt of “a number of highly-rated” Group of 20 countries from 2015 if their governments fail to enact reforms to curb rising healthcare spending and other costs related to ageing populations.

For Pimco, the political and social resistance to this sort of change is already showing itself to be significant both in Europe and the United States. People clearly don’t want to see pensions and benefits cut but politicians have already grown government and sovereign indebtedness close to their maximum. Accommodative central banks that helped them get there only ended up fueling credit, consumption and housing bubbles and distorting the balance of the economy away from production and into an increasingly bloated financial sector. That, clearly, ended in tears as finance itself needed bailing out and compounded the sovereign debt burden.

So if harder, longer-term choices and reforms are now needed, central banks ability to continually  reflate the world economy by monetary means alone is at best uncertain, Pimco argues. The risk of major upheavals along the way in Europe, for example, has the potential for major market volatility and economic seizures.

Investors in 2012 therefore mustn’t become entranced by the very considerable reflation attempts that will likely be delivered by the world’s central banks this year. The efficacy of policy actions too must be considered.

It highlights the risk of multiple liquidity traps — not only the classic Keynesian version where private sector savings rise regardless of low or zero interest rates, but also a supply-side liquidity trap where central banks pump liquidity into the banks only to have the latter deposit it back with the central banks for safety.

Either way, the money never enters the economy. Liquidity is abundant, but it remains disconnected from risk taking.

And the differing response of central banks around the world is creating a risk that a trapdoor closed in one region is ineffective as another opens somewhere else with global implications.

This may require even more provocative forms of monetary easing, whereby central banks perhaps could end up lending directly to the real economy without bank intermediation. That would be the “tipping point” for the liquidity trap to dissolve into a potential bout of inflation. Until then, policy rates have to remain near zero.

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