Why central bankers' composure is pure theatre

Federal Reserve, European Central Bank and Bank of England know extricating from stimulus policies is fraught with danger

Central bankers like to project a sense of serenity. The markets may be traumatised and the politicians may be panicking, but nothing fazes the technocrats in charge of our money. They are headmasterly figures: slightly detached but with their fingers on the pulse.

That's the image. In reality, the central bankers are in a funk about the health of their nations' economies and the challenge of extricating their institutions from the stimulus policies that have been responsible for what has, so far, been a tepid global recovery.

Why else would the Federal Reserve have bottled a decision on gradually winding down its bond-buying programme? Why else would the European Central Bank have surprised the markets with a cut in borrowing costs last week? Why else would the Bank of England feel the need to reassure the public that the 0.5% bank rate that has been in force since early 2009 would remain in place until unemployment came down to 7%, barring some unforeseen inflationary shock?

Mark Carney will face the press this week for the first time since he outlined Threadneedle Street's forward guidance in August and the governor will have the job of explaining why unemployment is now expected to come down faster than the Bank predicted three months ago.

On the face of it, this is an easy gig. Carney could stand up and say it is a jolly good thing the economy is doing better than expected and, therefore, interest rates can start to return to more normal levels a little earlier than planned. This, though, is the UK, and here there are really only three economic moods: periods when there is concern that the economy is not growing, periods when the worry is that it is growing too fast, and periods when a combination of steady growth and low inflation is considered too good to last.

For now, the UK appears to have moved from fretting about a triple-dip recession to fears about overheating without any intervening Goldilocks period. Accordingly, the financial markets will be focused in coming months on barometers of excess demand: the housing market, the trade figures, earnings and consumer spending.

Carney will have a period of grace before the markets start to demand action. In part that's because those indicators speaking of problems to come – the housing market and the trade balance – are flashing amber rather than red. In part, though, it is because problems are more acute elsewhere.

For the Fed, it is a question of when to taper, not whether. It wants to continue supporting what is a historically modest recovery with low interest rates and quantitative easing, but thinks the amount of new money creation each month should be reduced.

But it wants to do this without causing chaos either domestically or in the broader global economy. When the Fed chairman, Ben Bernanke, floated the idea of a gradual taper to bond-buying back in May, financial markets threw a fit. The laws of supply and demand have meant that bond prices have risen as central banks have bought more and more of them. The interest rate on a bond goes down as the price goes up, and these interest rates (bond yields) affect how much it costs firms and households to borrow over long periods.

Speculation about a Fed taper pushed up bond yields, which in turn made mortgages more expensive in the US. That put the dampers on the recovery in the housing market.

The same laws of demand and supply meant that electronically printing trillions of dollars has driven down the value of the US currency. It has also created a massive pool of funds looking for places around the world where returns were high. This was not in the west, where both growth and interest rates were low, but the emerging world, where growth was strong and borrowing costs much higher.

Even the threat of a Fed taper was enough to put this process into reverse. Money came flooding back out of emerging markets, putting pressure on their currencies as growth rates were slowing.

Europe has a different problem. Relief during the summer that the eurozone was at last coming out of an 18-month double-dip recession pushed up the value of the single currency. But a stronger currency means lower inflation because the cost of imported goods falls.

Inflation in the 17-nation bloc as a whole stands at 0.7%, well below the ECB's target of close to but just less than 2%. In those countries worst affected by the sovereign debt crisis it is already negative.

Deflation is not always a bad thing. In fact, if you are a saver it is a good thing because your money goes further. For debtors, though, a period of falling prices means that your debt burden increases. If interest rates are rising, then you can quickly find yourself in a situation where your debt is increasingly unpayable even if your income is going up at the same time.

What applies to individuals applies to countries also. Greece is already in a situation where it will require another bailout to make its debts sustainable and it wouldn't take much to push some other countries on the eurozone's periphery – Italy and Spain most notably – over the edge.

Economists at Fathom financial consultants have modelled what would happen to eurozone debt sustainability given plausible (if relatively generous) assumptions for budget deficits, growth rates and inflation. They found that if primary government budget balances (excluding debt interest payments) and growth rates were set at their long-term average, debt sustainability hinges on what happens to inflation.

At an inflation rate of 2%, the level of debt to national output (the debt to GDP ratio) declines for every country in the eurozone, including Greece. At 1%, and assuming a Fed taper leads to an increase in long-term interest rates of 1.5 percentage points in the next two years, debt becomes unsustainable for the peripheral eurozone countries. At zero inflation, even without a taper, debt sustainability is a problem for the core of the currency zone as well.

This threat explains many things. It explains why ECB head Mario Draghi moved so quickly to cut ECB interest rates last week. It explains why there is a lot of nervousness about the upcoming asset quality review of Europe's banks, since they are awash with eurozone bonds. It explains why the Americans, who know a taper is coming, are openly frustrated with Germany's failure both to reflate and to press ahead with banking union. And it explains why the sang-froid of central bankers is strictly for show.

Article Source : http://www.guardian.co.uk
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