A year and one week ago, the Bank for International Settlements’ 2013 annual report called for an end to super-loose monetary policy. It was ignored.
Yesterday the 2014 annual report did the same, in stronger language.
Between those calls, global equities and the S&P 500 have risen 24 per cent. Bond markets have rallied strongly in 2014. House prices everywhere have been booming. Central banks truly have been the investors’ friends these past 12 months.
It’s not often you see an industry association at odds with its members, but that’s what happens in the world of central banking.
The Basel-based BIS -- known as the central banks’ central bank -- is once again calling out its member central banks for being too loose with monetary policy, for solving short-term problems at the cost of greater long-term ones.
Yesterday’s warning was also an echo of the 2003 BIS annual report, in which the then chief economist Bill White warned that dangerous imbalances were building up in the financial system. Those warnings were brushed aside as well.
This time the BIS is talking about a post GFC world: the one that took five years to arrive after the BIS warned about it.
The 2014 annual report begins: “The global economy has shown encouraging signs over the past year. But its malaise persists, as the legacy of the Great Financial Crisis and the forces that led up to it remain unresolved.”
And then, under the heading “Global financial markets under the spell of monetary policy”, it says: “Throughout the year, accommodative monetary conditions kept volatility low and fostered a search for yield. High valuations on equities, narrow credit spreads, low volatility and abundant corporate bond issuance all signalled a strong appetite for risk on the part of investors.”
“Overall, it is hard to avoid the sense of a puzzling disconnect between the markets’ buoyancy and underlying economic developments globally.”
The US Federal Reserve began tapering its money printing six months ago, but has made it clear that it is no hurry to raise interest rates from the current floor of virtually zero. The European Central Bank actually cut rates recently, and talked about engaging in the sort of unconventional policies that the Fed has been using.
The Bank of England appears to be closest to a rate hike among the major western central banks, but its message has been confusing and puzzled markets have concluded that any move in Britain, where the official rate has been at a 300-year low for five years, is still a long way off.
Now, says the BIS, “the predominant risk is that central banks will find themselves behind the curve, exiting [from loose monetary policy] too late or too slowly".
“Arguably, it was precisely the slow pace of the policy normalization after 2003 that contributed to the strong booms in credit and property prices leading up to the financial crisis.”
Also: “Keeping interest rates unusually low for an unusually long period provides an opportunity to consolidate strained fiscal positions, but more often than not it lulls governments into a false sense of security that delays the needed consolidation.”
And… “regardless of central banks’ communication efforts, the exit is unlikely to be smooth. Seeking to prepare markets by being clear about intentions [which is what the Fed is doing] may inadvertently result in participants taking more assurance than the central bank wishes to convey.
“…even if the central bank becomes aware of the forces at work, it may be boxed in, for fear of precipitating exactly the sharp adjustment it is seeking to avoid.
“A vicious circle can develop. In the end, it may be markets that react first, if participants start to see central banks as being behind the curve. This, too, suggests that special attention needs to be paid to the risks of delaying the exit. Market jitters should be no reason to slow down the process.”
Underlying the BIS’s opposition to its central bank members’ monetary policies is its emphasis on what it calls the “financial cycle” that lasts 15-20 years, much longer than the business cycle of about eight years that central banks are normally focused on.
In other words, as current BIS chief economist Claudio Borio said, it’s like focusing on the ripples on top of the ocean rather than the underlying swell.
“Frameworks that fail to get the financial cycle on the radar screen may inadvertently overreact to short-term developments in output and inflation, generating bigger problems down the road.
“The temptation to postpone adjustment can prove irresistible, especially when times are good and financial booms sprinkle the fairy dust of illusory riches.”
Apart from setting up financial markets for a big bust down the track, the other problem with current monetary policy is that it is worsening (perhaps even creating) much greater income inequality.
When asset prices (shares and housing) are rising rapidly, the rich get richer. Meanwhile, real wages are flat or declining, and governments are cutting back on welfare to reduce budget deficits, so the poor are going nowhere.
On previous form, the latest warnings from the BIS will be ignored again.
Ten years ago the Federal Reserve, The European Central Bank and the Bank of England all misread the risks that were building up and which the BIS identified at the time. Yes, it took another four years for the crisis to hit, during which time a lot of money was made by investors, but as the BIS is warning in this year’s annual report, the crunch was that much harder when it came.
And you would have to say the central banks’ failure last time weakens their claim to be right this time.