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Central banks have lost the plot

The recent annual meeting of global central bankers at Jackson Hole came at a time when investors are beginning to question the wisdom of ongoing extreme monetary stimulus. Contrary to many critics, my concern is not that these measures have not worked. Rather, I maintain they’re simply not needed, as the global economy is as good as might be expected once allowance is made for slowing potential growth and falling commodity prices. To my mind, the far bigger global risk now is the impact of persistent misguided extreme monetary measures on financial stability.

Global growth has been OK

Global economic growth in recent years has been commonly perceived as disappointing, which in turn has been attributed to the scale of the financial shock endured in 2008. Indeed, in developed economies – which are most responsible for today’s extreme monetary measures – annual GDP growth among members of the Organisation for Economic Cooperation and Development (OECD) averaged 1.7% p.a. in the five years to end-2015, compared with 2.8% p.a. in the five years to end-2007.

Around half of this slowdown has reflected a decline in working-age population growth (from 0.8% p.a. to 0.2% p.a.), with the other half reflecting weaker growth in GDP per working-age person (i.e. weak productivity). In other words, most of the slowdown in growth among developed economies since the financial crisis has reflected weaker potential growth.

Indeed, as the chart below shows, economic growth across the developed world in recent years appears to have been above potential, as evident from the fact that unemployment rates have trended down. The unemployment rate averaged across the OECD has declined from a peak of 10.4% in March 2010 to 6.4% by March 2016. Only in Europe is the unemployment rate still clearly above GFC lows, but it has also fallen notably in recent years.

Unemployment rates in selected OECD economies

Source: OECD

The Reserve Bank of Australia acknowledged decent growth in the developed world in its August 2016 Statement on Monetary Policy, stating, “Labour market conditions in most advanced economies have continued to improve and a number of these economies are close to full employment.” Crisis, what crisis?

Global inflation is not perilously low

The argument that inflation across the developed world is perilously low, suggesting we are at risk of a deflationary slump, also does not stand up to scrutiny.

As the chart below shows, headline consumer price inflation across the OECD is relatively low at present, with prices up 0.9% in the 12 months to 30 June 2016, compared with an average since 2004 of 2.1% p.a. Most of this drop in inflation reflects the decline in commodity prices in recent years. In the year to 30 June 2016, core OECD consumer prices (i.e. excluding food and energy prices) were up 1.8% – equal to their (relatively stable) average since 2004.

The case for extra-ordinary monetary stimulus in most of the OECD seems very weak. In the case of the Euro-zone, growth has also been above potential, though the unemployment rate remains elevated compared to pre-financial crisis levels. It’s also the case that core inflation in the Euro-zone is below average. Europe seems to warrant somewhat more monetary stimulus than Japan and the United States, but even in Europe the case for extreme monetary measures seems weak – unemployment is trending down and core inflation is still comfortably above zero (at 0.9% in the year to 30 June 2016).

Financial instability is the biggest risk

Against this backdrop, it is staggering that key policy interest rates are still near-zero in many regions, and central banks have massively enlarged their balance sheets through aggressive buying of financial assets. Japan is the most extreme example, with the Bank of Japan’s balance sheet now almost equal to that of Japanese GDP even though core inflation is above average and the economy is close to full employment!

The impact of these extreme monetary measures is highly distortionary for the global economy. As the charts below show, sovereign 10-year government bond yields are now at their lowest levels in at least a century, and price-to-earnings valuations across many markets are approaching levels that have not been sustained since the dotcom bubble period earlier last decade.

The worry is that the bubble in bond yields now appears to be slowly but surely flowing through into equity valuations. Unless global central banks change course – and correctly recognise the reasons for apparently low global growth and inflation have little to do with deficient demand – they are at risk of creating yet another boom-bust cycle in asset prices within the next year or so.

We’re heading the wrong way and it’s time to turn back.

Investment implications

For investors, the implications of aggressive central bank policy actions represent a double-edged sword.

On the one hand, despite weak global earnings, maintenance of easy credit policies may well push up global equity markets over the near term as price-to-earnings valuations (while now above average levels) are still reasonable value against the very low global bond yields on offer. As equity markets continue to rise, the risk increases of a harder and more destabilising decline in equity markets later.

While it is difficult to time when the current market euphoria will end, we are entering a period when increased caution is warranted.

To the extent investors still desire some exposure to the market – if only because of the attractive dividend yields on offer – they might consider more defensive high-income focused sectors and strategies or risk-managed equity products which offer more downside protection.

 

David Bassanese is Chief Economist at BetaShares. BetaShares is a sponsor of Cuffelinks, and offers risk-managed Exchange-Traded Funds such as listed on the ASX such AUST and WRLD. This article is general information and does not consider the investment circumstances of any individual.

 

4 Comments
Warren Bird
September 11, 2016

I don't think they've "lost the plot" at all. They might be running easy monetary policy longer than one group of economists thinks is necessary, but this is a judgment call rather than a matter of fact.

You have to think of the level of policy rates as reflecting two things. First is the neutral rate, the level of cash rates that is consistent with steady growth and no change in inflation from a reasonable level. As David's article points out, potential growth has fallen, for a few different reasons. Also, inflation mightn't be as dire as some have feared, but it is very low. For these and other reasons, neutral rates are very low. In the US and Europe I'd venture to put them as low as 1.5-2.0% compared with the 4-5% we got used to a decade or more ago.

The second element is how far below the neutral rate the policy makers judge it to be necessary to lift an economy struggling to grow sustainably at potential. Clearly the central banks currently have a more cautious view of the outlook than David does. So they have rates further below neutral than David thinks they should.

By all means debate both of these components, but please give the very experienced, well resourced teams of experts who make up the central banks a little more benefit than to arrogantly assert that they've lost the plot. The inference being, of course, that the one making the criticism has all wisdom on their side. David's a good economist, but that doesn't give him quite that level of bragging rights.

I personally don't think that policies are 'madness'. I shudder to think how bad the world economy would have been without the aggressiveness of the central banks, who've certainly seen the problem and acted far more purposefully than any of the elected officials who decide government spending and taxing.

Rick S
September 09, 2016

Yes, couldn't agree more. I'm not sure what it is they're trying to fix, but the risk of bubbles in the economy is certainly increased by ultra low interest rates. And there's the old saying .. The first sign of madness is continuing to do the same thing and expecting a different outcome!

PaulU
September 09, 2016

That horse has bolted. I have lifted part of an article from John Mauldin - Mauldin Economics....says it all...and far better than i ever could....

"The ultra-easy monetary environment of the US has produced 1% GDP growth over the last six months, almost no productivity growth, and an employment reality in which seven million men between the ages of 25 and 54 – prime working age – are no longer even looking for work. The only way you can possibly think your monetary policy is working, Dr. Fischer, is if you are measuring it only by the Dow Jones average. Which is not what most of us out here in the real world actually think about when we think of a thriving economy.

Whether equity prices are decent, indecent, or somewhere in between should have nothing to do with the Fed’s monetary policy decisions. Their job is to encourage full employment and to minimize inflation. That’s it. Propping up the stock market is not in the Fed’s wheelhouse, yet it has obviously become the main driver of policy since Ben Bernanke and arguably since Alan Greenspan."

DougC
September 08, 2016

David Bassanese has made several good (and long overdue) points here. In one particular regard, the ill-founded policies of central banks have turned investment into gambling. Again, this week, the US stock market - now addicted to QE (free money and increased debt) rose on the expectation of no imminent interest rate rise, while the indices of industrial production declined ! Do central banks honestly imagine that this is the way out of economic difficulties ?

 

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