“The constraint of the ‘zero lower bound’ on a nominal interest rate, which was believed to be impossible to conquer, has been almost overcome by the wisdom and practice of central banks. It is no exaggeration that [ours] is the most powerful monetary policy framework in the history of modern central banking,” BOJ Governor Kuroda, displaying ominous levels of hubris
‘The existential threat to market confidence and trigger for a true panic remains a collapse in investor faith in central bankers, who remain perched on their pedestals for now. To maintain precious credibility, it would be wise if they stood back from healthy bursts of volatility like we are seeing, rather than rushing to soothe nerves…‘ Macro Weekly, 20th October 2014
That ‘existential threat’ point I made back in 2014 remains key – unfortunately, instead of standing back, central bankers keep tinkering and risk squandering their most precious policy tool – credibility. What if rather than the ‘wisdom’ of central banks as Kuroda would have it, the negative rate experiment undermines bank profitability and thus credit creation? What if it leaves life insurers facing a solvency crisis and forces households to save more, thus deepening the ‘liquidity trap’ extreme monetary policy is meant to overcome? While weak nominal growth and thus growing deflation risk is the underlying issue, uncertainty regarding highly experimental central bank policies, their predictability and effectiveness is the big concern right now, and has partly driven the rout in global financials.
The Swedish central bank last week cut its repo rate to minus 50bps, in a country growing at 3.5% this year and with one of the most overheated housing markets anywhere (up 18% last year). They did this purely to meet a typical simplistic and (given the structural technological/demographic headwinds) misguided inflation target. Some will call this an effort at competitive devaluation, but it’s striking that both the Swedish Krona and JPY rallied after an initial selloff on negative rate announcements. While the Fed was suggesting four rate hikes this year (which markets never really took seriously), many if not most US investors are now talking of no further rise this year and even a rate cut.
Many observers are beginning to ask: do central bankers really know what they’re doing? This is all highly experimental monetary policy with minimal academic literature to support it and the unintended consequences on tighter liquidity by squeezing the private banking system (and in a fractional reserve system, banks ‘create’ money via the credit multiplier) and fuelling asset bubbles will likely be significant. Eventually the consumer price inflation targeting ‘fetish’ will be abandoned by policymakers.
The core issue for central banks as I cover repeatedly is how to bring excess savings and structurally weak investment demand into balance via an ‘equilibrium’ price for capital which has driven ever more intense levels of ‘financial repression’ to prod savers to spend, despite the secular demographic backdrop and digitizing growth/consumer spending patterns. Negative rates in the US are now being discussed by mainstream commentators, despite nothing in the macro data to suggest that would be justified on either core inflation or growth grounds.
Negative rates are probably net tightening financial conditions and the ‘signalling’ impact of these extraordinary moves on investment return expectations both in financial markets and the real economy could well end up boosting precautionary savings and depressing investment further. It also has so far contributed to widening credit and equity risk premia, but the biggest risk is that bank’s lending confidence starts to reflect their plunging security prices, squeezed yield curve ‘carry’ and shrinking net margins so the selloff risks becoming to some degree self-fulfilling. Clearly, regulatory bank stress tests now need to include the ability to cope with deeply negative rate environment in the next global downturn.
Markets have seemed in recent weeks on the edge of a nervous breakdown, with investors overwhelmed this year by a rapid sequence of tail risk panics, from (we think misplaced) fears of a dramatic RMB devaluation to oil falling into an abyss (in our view far more likely to be bottoming) and now a banking meltdown, all of which pushed the MSCI ACWI to a 20% decline from its highs last week. Despite the old adage that ‘news follows prices’, much of the recent selloff looks largely psychological/technical.
However, central bankers need to stand back and remember the PBoC governor’s wise words that they are ‘neither a god nor a magician, there is no way we can wipe out all uncertainties’ i.e. act with extreme caution in extending the negative rate experiment until unintended consequences become clear. It would certainly be helpful if the ECB reassured markets on Eurozone bank funding, by offering backstop repo lines if necessary and broadening its range of credit instrument purchases.
Investors need to get over the psychological scars of 2008 and accept that very few have the insight to spot a true ‘Big Short’ moment. Indeed, the uninspiring recent record of leading hedge funds, from the US biotech debacle to the short Euro frenzy back in December underlines that groupthink has never been more potent a force in markets. As about half the headline ‘capital flight’ is in fact very healthy external debt deleveraging, that makes the current popular ‘China is running out of FX reserves’ narrative another crowded bet likely to implode, with a little help from Chinese central bankers schooled in Leninist brute force.