Why central banks have locked up capitalism

It’s supposed to be free-market capitalism, but animal spirits are in a zoo these days, and central bankers are the zookeepers.

Those looking for a Reserve Bank rate increase to stem the rise in house prices are going to be disappointed: if anything rates will have to be cut again.

Last week’s global sharemarket riot was partly due to a sudden recognition that global central banks are losing the battle against disinflation, and perhaps even deflation.

Central banks are in the awkward position of being fully in control of the global economy. It’s supposed to be free-market capitalism, but animal spirits are in a zoo these days, and central bankers are the zookeepers.

Friday’s bounce happened because two of them – Andy Haldane, chief economist of the Bank of England and James Bullard, President of St Louis Federal Reserve Bank – publicly acknowledged what markets were already seeing and suggested that monetary stimulus might have to continue for a while yet. Bullard said the end of QE might be deferred and Haldane said rates could stay low for longer.

Global central banks are no longer inflation-fighters; they are now deflation-fighters, trying to get inflation up, not down.

CPI inflation everywhere has already been under pressure because of weak demand from post-GFC cautionary saving and balance-sheet repair, as well as cloud technology, robotics and automation putting downward pressure on wages and costs.

To that cocktail has been added a 20 per cent fall in the oil price in four months.

Any sharemarket that has been rising without much of a correction for two years is going to be looking for an excuse to fall, and that seems to have been the one for October 2014 – fear of deflation.

It wasn’t fear of a new economic slowdown, even though the German growth has fallen sharply and threatens to drag Europe into a triple-dip recession. In fact, if anything, global growth forecasts are being upgraded slightly.

What’s changed is a new skepticism about the ability of central banks to meet their inflation targets next year.

Five-year inflation expectations embedded in the interest rate swaps market have fallen sharply – in the case of Europe, below 1 per cent for the first time since 2008 and for the United States below 2 per cent.

As Gerard Minack of Minack Advisers wrote last week: “In a world of generally expensive assets, arguably the most over-valued commodity is central bank credibility.  If the ECB or the Fed traded as stocks they would be on a triple-digit PE.”

So what happened last week was the beginning of a “de-rating” of central bank credibility.

To put it another way, here’s Adrian Miller of GMP Securities, quoted in the Financial Times over the weekend: “Markets need to check into the Betty Ford Center and go into rehab, to wean themselves off this addiction to central bank support."

The question is, what does all this mean for Australian interest rates?

Nothing in the short term -- Governor Glenn Stevens has made it very clear that the RBA is extremely reluctant to do anything for a long time.

But it must be possible now that the next Statement on Monetary Policy, due out in three weeks, will contain downward revisions to both growth and inflation.

The one possible counter to that is further dollar weakness in response to lower terms of trade, which increases imported prices, and therefore inflation.

But last week’s action on global markets, or more importantly what was behind it, means that Australian interest rates may not be increased in 2015 and may even have to be cut.