Saturday, 4 February 2012

Will the great interest rate gamble pay off?

Will the great interest rate gamble pay off?
By flooding the system with 'free’ money, the central banks could be storing up trouble.

Since arriving at the European Central Bank, Mario Draghi has engineered a sort of Club Med putsch, sidelining the German hawks and embarking on monetary activism - Will the great interest rate gamble pay off?
Since arriving at the European Central Bank, Mario Draghi has engineered a sort of Club Med putsch, sidelining the German hawks and embarking on monetary activism Photo: REUTERS
Bravo, Mario Draghi, the European Central Bank’s new president. Everyone assumed that this mild-mannered Italian would be so determined to prove himself to his Bundesbank masters that he’d be even more German than the Germans in pursuit of the principles of sound money. The profligate Italian of caricature would become the hair-shirted German, lashed to the mast of the Bundesbank’s anti-inflationary tradition.
In practice, he’s proved anything but. Since arriving at the ECB, Draghi’s engineered a sort of Club Med putsch, sidelining the German hawks and embarking on the kind of unconventional monetary activism that for several years now has been the hallmark of the US Federal Reserve and Bank of England. He’s been bold, and he’s been decisive.
And it appears to have worked. In promising unlimited funding to Europe’s stricken banks, he’s very likely saved the Continent from the Lehman’s moment for which it was undoubtedly heading. Both Spain and Italy have also found it easier to fund themselves in financial markets, and spreads have narrowed. Banks have been encouraged to borrow cheaply from the ECB to buy higher-yielding government bonds – the “Sarkozy carry trade” – which in turn has allowed countries to finance themselves less expensively.
By the time this month’s auction is over, the ECB will have doled out nearly one and a half trillion euros of “free” money to help keep the banking system alive, with much more to come over the months ahead.
Nobody is under any illusions. These actions have not succeeded in vanquishing the crisis. Underlying structural issues remain unresolved, and it is most unlikely that the starvation diet to which much of the eurozone periphery has been condemned will result in robust recovery. But Mr Draghi has at least prevented the patient from dying on the slab. Two cheers for that.
Even so, you have to wonder where all this “financial repression” – the artificial depression of interest rates – is going to lead. Since the crisis began, the world’s major central banks have engaged in a degree of intervention in financial markets quite without precedent in the modern age, if ever. In seeking salvation from the banking maelstrom, interest rates have been cut close to zero, and long-term bond yields suppressed to historic lows.
In Britain, the Bank of England has already bought up more than a third of the conventional gilts market, or rather more than a quarter of the entire national debt. Since quantitative easing began, the Bank has hoovered up gilts to the value of more than a half of those issued by the Debt Management Office, greatly easing its task in financing the deficit.
Nor is this the limit of the UK’s financial repression. Banks have been required by regulators greatly to increase their liquidity buffers, creating another big source of demand for UK gilts. It’s the same in the US and Europe.
These sovereign debt holdings have created new threats. Given the inflated size of the buffers, it would require only a quite small rise in interest rates – one or two percentage points – to create additional solvency problems for the banks, as we saw with the Franco-Belgian bank Dexia, which had to seek a bail-out after its eurozone sovereign debt turned toxic. Yet it is the rapid expansion of central bank balance sheets which is beginning to cause greater concern.
There are a number of justifications for this expansion. One is that by printing money, the central bank counters the contraction in credit being caused by private and banking sector deleveraging. By so doing, the monetary authority keeps the deflationary bogey at bay.
But it also allows governments to issue debt at lower interest rates, reducing servicing costs and eroding the real value of the debt. Economists have described it as a form of stealth taxation, or debasement.
It’s not an ideal way of proceeding, and it’s deeply unfair on savers, who through negative real interest rates are obliged in effect to subsidise both the Government and other debtors. It is, however, generally considered less painful than the alternative of even greater fiscal austerity.
For the moment, it’s hard to argue that such actions are inflationary. Today’s relatively elevated levels of UK inflation are not directly caused by money-printing, but by devaluation and the spike in energy prices. The problem is not too much money, but not enough. Yet intuitively, one knows that some way down the line, such practices will have inflationary consequences which, once out of the box, will be extremely hard for central banks to put back in again.
Only last week, the US Federal Reserve committed itself to keeping interest rates close to zero for another three years. By the time we get there, the US will have had seven years of essentially “free” money. Nobody knows what the long-term consequences of such financial repression might be. As I say, it’s never been tried before. But we do know from the way unduly loose monetary policy helped stoke the credit bubble in the first place that the potential for things to go very badly wrong is high. Central banks frequently seem to do more harm than good.
In the US, credit conditions already seem to be easing. Recent evidence points to sustainable growth of some 2 to 3 per cent. As the economy normalises, so must interest rates. The fear must be that we’ve grown so used to and reliant on ultra-low rates that the economy won’t be able to tolerate anything else. The dangers are all too obvious.

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