Central banks and all tomorrow’s parties: James Saft

July 1, 2014

July 1 (Reuters) – In focusing on their traditional role as
guardians of the punchbowl, central banks are failing to see how
tonight’s party always slides into tomorrow’s need for a
hangover cure.

In a barbed annual report, the Bank for International
Settlements, the so-called central banks’ central bank, attacks
policymakers for a misguided emphasis on the short-term ups and
downs in the economy and a blindness to the longer-term costs.

The critical distinction here is between the business cycle,
a six-to-eight-year cycle of ups and downs which central banks
seek to manage, and the financial cycle, which is most easily
viewed in terms of asset prices and which can last upwards of 20
years.

“Asymmetrical policies over successive business and
financial cycles can impart a serious bias over time and run the
risk of entrenching instability in the economy,” the BIS report
said.

“Policy does not lean against the booms but eases
aggressively and persistently during busts. This induces a
downward bias in interest rates and an upward bias in debt
levels, which in turn makes it hard to raise rates without
damaging the economy – a debt trap.” (here)

Like managing a fractious child with sugary drinks at the
dinner table, central banks gain some measure of control over
the business cycle, though arguably this is diminishing, but are
dismayed to find themselves with longer-term problems at least
partly of their own creation.

The best evidence that this is true comes from asset prices,
which are high and out of whack with economic fundamentals
against a backdrop of growing global indebtedness since the
financial crisis.

This argues that the crisis did not end the financial cycle,
but instead forced central banks to put in place policies to
extend it.

None of which is to say that the conditions which are
causing central banks to keep rates very low aren’t real and
grave. Inflation is low and looks unable to consistently meet
targets, job growth is patchy and biased towards lower wage
areas, and wage growth for those in work is disappointingly
poor.

All of which makes the current set of policy errors more
understandable, but none of which makes the trap of growing debt
and weak growth easier to escape.

OF POLICY AND PEOPLE

Central banks argue they can manage these risks with the
help of something called macroprudential policy, essentially
oversight and regulation intended to keep the banks and
financial system from overheating.

The Bank of England’s recent foray into the mortgage market,
in which it introduced new guidelines intended to cap the number
of very highly indebted house buyers, is one such example.

The BOE recognizes, rightly, that surging house prices
attract more capital, whose owners seek to increase their
returns by borrowing as much as possible to maximize gains.

The problem with macroprudential policy generally, and the
British mortgage market changes in specific, is that, while they
may stop some bad loans from being made, they do little to
change the psychology of a rising asset market. You can argue
that by intervening, a central bank will give the illusion that
they are managing the market, making it less risky and an even
better bet.

Also at issue, and a source of some risk, is how central
banks can credibly communicate their intention to withdraw
support and raise rates.

As we saw last year, central banks can become boxed in by
their attempt to clearly communicate what policy is coming down
the road. The Federal Reserve’s attempt to lay the groundwork
for tapering proved disruptive to financial markets, especially
some emerging markets. That experience may well leave the Fed,
and other central banks, unwilling to speak frankly about
upcoming rate rises for fear of upsetting the very conditions of
reasonable growth which make them possible.

In other words, the reaction function, the fact that markets
are made up of people who anticipate, react to and attempt to
game incoming information, makes forward guidance all the more
difficult.

Thankfully, the potential cures for the punchbowl trap all
work better once it is taken away.

While tighter credit conditions may do some damage to the
economy and cause defaults, those very defaults help to better
channel capital and credit to where it will generate better
levels of longer-term growth.

While the BIS’ critique is on target, investors should be
very cautious about expecting it to be heeded.

The past 25 years are not encouraging for those hoping
central banks will trade a bust of a party tonight for a better
workday tomorrow.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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