Will central banks help or harm us?

The consequences of prolonging ultra-low interest rates to fend off the threat of deflation could be more harmful than deflation itself.

Less than a month after the US Federal Reserve ended its third quantitative easing program, three of the world’s largest central banks have acted (or are about to act) to lift stimulus further. We know about the Bank of Japan and its rationale. Japan is insolvent and has opted to print even more money, not only to buy its own bonds but also to purchase foreign assets. 

In effect, what we are seeing as the global economy expands and accelerates further is global policy becoming even more stimulatory. This isn’t the way things were intended. So while China’s surprise rate cut on Friday was small potatoes (comparatively), China, unlike most other countries, has plenty of ammunition to use. This might only be the first in a series of cuts. Then we have the ECB, apparently moments away from unleashing its own QE program.

That such moves are met with universal applause is a little disconcerting. Especially in the wake of what is clearly the heightened anxiety of the Bank for International Settlements (the so-called central bank to central banks).  

In a speech last week, the Bank’s deputy general manager Hervé Hannoun suggested that the current strategy employed by central banks -- specifically of reducing debt-servicing ratios and reducing long-term interest rates -- was probably not appropriate any more given “the end of the emergency”, now that the recovery was well underway.  

Indeed, you can get a sense as to just how out of whack global policy is at the moment when using the Taylor rule: a simple tool that gives a guide as to what interest rates should be based on inflation and growth. Using this, the BIS suggested that interest rates in the advanced world should be closer to 3 per cent rather than zero -- and that was back in 2012.

The BIS are urging central banks to think about five key issues in conducting policy. One is “whether a prolonged period of unconventional monetary policies is incentivising more debt and is therefore beginning to do more harm than good”.  

The global evidence is pretty clear. The US and Japan are still ramping up public debt at a rapid pace, running sizeable budget deficits with little to suggest this is going to change any time soon. On average, the BIS estimates that non-financial debt in advanced economies was about 280 per cent in 2014, compared to below 250 per cent immediately prior to the GFC. It makes the point that any deleveraging that has occurred in the private sector has been more than offset by a run-up in public debt.

All low interest rates have done is to incentivise “borrowers to take on even more debt, making an eventual rise in rates even more costly if debt continues to grow”. The BIS also warns that low rates are breeding “complacency among creditors” and that “long periods of complacency are usually followed by episodes of ‘market tantrums’”.

This isn’t a great situation to be in, yet central banks plough on anyway.The mantra now is that deflation is a threat that must be dealt with.

Yet the BIS argues that “it is not clear from the data that there has been a significant rise in the risk of deflation… headline inflation in major economies has been falling steadily since its 2011 peak, but the recent decline is largely explained by falling commodity prices”. This is a point I have highlighted myself. Moreover, market pricing isn’t factoring in nor pricing in a risk of deflation. 

The more important issue that the BIS raises, however, is that even if deflation pressures were building, the costs of deflation would be quite low and akin to Japan’s experience, rather than the experience of the US during the great depression.

So the question is: why do it? Why try and protect against deflation, when the cost of holding interest rates at ultra-low rates -- financial instability, inflation -- are real and much more likely than deflation? And no one should be foolish enough to think we don’t live in a high inflation world. We do, but it’s manifesting through asset pries alone at this point, rather than consumer inflation. It’s still inflation.

Another very serious question that the BIS encourages central banks to ask themselves is: what will happen in the highly likely scenario that central banks fail, if even further monetary easing is regarded as insufficient? That central banks are persistently called on to deal with deflation and low growth six years after the GFC suggests something is amiss, doesn’t it?

As the BIS points out, “if nonconventional monetary policies [continue to] disappoint, we can expect a proliferation of “new” ideas on how to circumvent the problem. This is not a good thing given the “the trend in the public debate towards more and more eccentric proposals”.

When an institution as highly regarded as the BIS is concerned about the ever more loopy ideas that get thrown around policy circles, and then regurgitated by mindless, dead-eyed economists around the world, you know there is a very serious problem. 

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