Carney & Bernanke have to project gloom that satisfies markets without deterring businesses investing and consumers spending
For the next few weeks and months, Europe's central bankers will be arming themselves for yet another battle with the bond markets. After a brief period of calm following the Spanish debt crisis last year, interrupted only briefly by Cyprus flirting with bankruptcy, the bond markets are tense, poised for a seismic economic jolt.
The situation is complicated, undemocratic you might say, as the world's largest pension funds and sovereign wealth funds vie with each other to maximise their returns safe in the knowledge that only a few people at the heart of the financial system have a clue what they are doing.
One month they pile into sovereign bonds, the next they turn to stock markets. Driven by fear and greed, they swim the international money markets like sharks scenting a profitable kill.
Mark Carney, the Bank of England's new governor, was being sniffed by the markets for a sign of weakness or indecision within hours of his arrival last week.
Four days into his five-year tenure and he took the plunge into giving forward guidance to the markets. The guidance said: "There will be no shocks. We intend to maintain ultra low interest rates for some time", or words to that effect. Mario Draghi, his counterpart at the European Central Bank, took the same step just 90 minutes later, promising an "extended period" of record-low rates.
The problem faced by both men is that much of the bond markets is focused on the US where some major investors believe an end to ultra low rates is inevitable sooner rather than later.
Already, some of the biggest investment funds that populate the bond markets are wrestling with the prospect of the Federal Reserve not only pushing up interest rates within a couple of years, but also bringing its $1 trillion (£670bn) a year bond buying programme to a halt before next summer. After years of feeding on cheap dollars, the party might be over.
And if the US pulls back, there could be negative effects to inflation, commodity prices and the real economy.
The Fed's QE spree, which is set at $85bn a month, makes it one of the biggest bond buyers on the planet. Mostly, it buys US government bonds and in so doing effectively underwrites the Obama administration's growing debt pile.
Until a couple of months ago the only worry among bond investors was how the Fed's purchases pushed up the price of the remaining bonds left for sale. A higher demand for US Treasuries sent returns, known as the yield, spiralling down and encouraged many investors, often against their better judgment, to put their funds into US, UK and European stock markets.
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| Bank of England's news governor, Mark Carney, like his counterparts at the Federal Reserve and the European Central Bank, has a tough balancing act to master. The huge recovery in the FTSE 100 during the first half of this year can partly be attributed to a share-buying frenzy with money previously locked up in the bond market. |
Such was the rise in the stock market that Fed boss Ben Bernanke has now hinted he might start to slow QE. Not switch it off, just slow the pace of growth.
Pimco, one of the biggest bond fund managers, promptly experienced a huge outflow. Its boss, Bill Gross, wrote last week, seemingly with his head in his hands, that panicky investors were blinded by the smoke from recent battles to the long term outcome of the war.
He pointed to the Fed's high tolerance of inflation. Just as the Bank of England has allowed inflation to yo-yo and peak at 5%, so the Fed is happy for its core inflation rate of around 1% to increase to beyond its 2% target, something Gross said would make inflation irrelevant as a guide to behaviour for many years. Then he talked about the likelihood of a dramatic fall in unemployment to the 6.5% level Bernanke has targeted. This target, he believes is also many years away.
"Fed [0.25% interest rate] will not increase until at least mid-2015 and even then subject to a consistently strong economy that produces 2%+ inflation. I wonder if we can get there in this decade to tell you the truth," he said.
Far from endorsing the Fed, he is even gloomier, saying that short bursts of goods news on the housing market or car buying belie the problems all western economies face of growing health and care costs, competition from Asia that drives down wages and a constant technological drive that is de-skilling important white-collar industries from architecture to the media.
"The Fed, we would argue, is too cyclically oriented, focusing substantially on housing prices and car sales. And speaking of housing, since mortgage rates have risen by 1½% in the last six months and the average monthly check for a new home buyer is up by 20–25% as well, then as I tweeted several weeks ago, 'Mr Chairman are you serious?'" Growth will be negatively influenced, Gross added.
Carney faces a similar problem to Bernanke. He needs to convince the bond markets that a decent run of car sales and a booming housing market in the south east of England does not make for a surging economy. And yet he won't want to sound so gloomy that he deters businesses from investing and consumers from spending.
There are many economists, mostly on the monetarist wing, who believe the underlying state of the economy is sound, and with the good times are so close we need to calm things down with higher rates.
So every time Carney sounds even modestly upbeat he will find himself stinging his audience with a bit of gloom.
Can he maintain this balancing act? As we have seen in the last few weeks, Bernanke only needed to allow the corners of his mouth to lift a little, to allow a slight smile, and the bond markets took flight.
The answer must be that central bankers can maintain their balance if they just keep recycling the same message every month for the next few years. Fund managers will, no doubt, read too much into one speech versus another and send demand rocketing, or the reverse, only for the status quo to reassert itself, which is great if you are a mortgage holder or have high debts. Low interest rates for longer is your saviour.
But the bond markets never lose. They will turn away and seek returns elsewhere, sniffing weakness in developing world countries or obscure stock markets. These investments could turn into nasty bubbles and crash, which means people – governments and small investors – getting hurt.
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