INSIDE INVESTOR: How central banks have manipulated markets

All the old rules have been thrown out the window.

Not that long ago, if a central bank decided the economy was slowing too quickly, it would cut interest rates by simply lowering what is known as the ‘overnight rate’ at which banks borrow.

They then dutifully passed on the cut to customers. And that had two effects. It lowered costs for consumers or businesses that already had borrowed money, which gave them more to spend.

It also encouraged those who were reluctant to borrow to take up new loans for investment or consumption purposes.

So there was a pretty strong relationship between interest rates and, say the stock market. During an economic downturn, the stock market would weaken and interest rates would be lowered in an effort to give things a little kick along. The two trends were almost in lockstep.

That old relationship has not existed for more than three years in the world’s biggest economy, America.

Interest rates have been pushed consistently lower – where they now sit just above zero – while the stockmarket has now broken through to new records.

The explanation as to why is simple enough. America’s central bank, the Federal Reserve has embarked on an unprecedented program of deliberately trying to depress interest rates and to slash the value of the greenback.

It has done this through a process of what is known as quantitative easing. While the mechanics are quite complex – issuing new debt and buying back old debt – it amounts to old fashioned money printing.

To a degree, it has worked. The mighty greenback has weakened which has made America more competitive on the international stage and corporate earnings have risen, helping rejuvenate America’s manufacturing base.

In recent weeks, Japan has embarked on an even bigger program of money printing which has sent shockwaves through global markets, particularly the gold price. Even Europe, which for years stubbornly refused to engage in the practices, now professes it will do  “whatever it takes” to ensure the survival of the European Union.

There are a great many market sages who wonder and worry just how long this can continue, that the elastic is being stretched almost to breaking point.

From our viewpoint, this activity explains why a large part of Australian business, particularly our manufacturing and service industries, are struggling. And it explains why many of our non-resource companies have seen their earnings contract in recent years.

Our dollar is much higher than it should be, only because every other country is actively pushing down the value of theirs.

Luckily, our economy is in fine shape and our finance system healthy. So our Reserve Bank has not needed to engage in these practices. But our economy and our stock market have been penalised by a currency that is much stronger than it need be.