Are central banks across the world suddenly waking up to the fact that artificially low interest rates have been storing up trouble for us all?
Just a couple of weeks ago, Bank of England governor Mervyn King admitted that “monetary policy around the world may have been too accommodative.”
And now the Bank for International Settlements – also known as the central bankers’ central bank – has suggested that the massive financial imbalances in the global economy might just have something to do with the easy credit conditions of recent years…
The Bank for International Settlements has warned that central banks might have to hike interest rates more sharply than anyone currently suspects. Inflationary pressures are ‘now seen to be greater than they have been for some time’, while soaring prices of assets from stocks to property across the globe have suddenly got the bankers worried.
As Paul McCulley of bond investment specialists Pimco points out, and central banks now seem to be realising, ‘too much focus…[on] stabilising goods and services inflation on one-to-two-year horizons is a prescription for boom and bust in asset prices’.
Of course, it’s debatable whether central banks have even done a decent job of targeting goods and services inflation. Low inflation owes a lot more to Chinese factory workers and statistical sleight-of-hand than it does to central bankers.
Even the BIS admits that consumer price inflation figures have been fudged. “The concept of ‘core’ inflation is based on the exclusion of volatile price components, but the price of excluded energy has been trending upwards for over three years. It is the reality of consumers facing higher costs for energy and housing services that could still pass through to wage settlements.”
General manager Malcolm Knight said banks would have to be “pragmatic” when raising rates and consider the consequences for financial markets. But he broadly welcomed the recent pullback in global stock markets and commodity prices.
“It appears to me that what we are seeing is a generalised increase in the risk aversion of asset holders. That in and of itself is not an unhealthy phenomenon because we have been saying for some time that there was an underpricing of risk.”
It’s nice to know that the central banks have been warning us that this was going to happen all along. But who, exactly, was responsible for the “underpricing of risk” in the first place? Who was it that reassured markets that any time asset prices looked set to take a dive, interest rates would be slashed to cushion the fall?
That’s right – central bankers. Or more accurately, the central banker’s central banker – former Federal Reserve chief Alan Greenspan.
The “Greenspan put” as it is known, refers to the faith that Wall Street (and by extension, investors across the rest of the world) has that the Fed will protect them from falling asset prices. It stems from Mr Greenspan’s habit of slashing interest rates whenever an economic crisis loomed, thus inflating a series of asset bubbles which culminated in the US housing bubble (for more on this topic, click here: Alan Greenspan – the savings saboteur).
The trouble with the “Greenspan put” is that it lulls investors into a false sense of security. Edward Chancellor on Breakingviews.com cites economist Hyman Minsky, who argued that ‘during periods of calm…borrowers take on more risk and lenders accommodate them. As a result, the margin of safety in the financial system is diminished’.
It’s not hard to see this in effect across the globe. Investors have been merrily snapping up the debt of emerging market economies, so that yields (at least, until recently) have hit record low levels compared to similar US and UK government bonds.
And its effects are also visible in domestic markets, like the UK property market. Banks might be reining in lending criteria for credit cards and personal loans, but they’re still falling over themselves to dish out ‘sub-prime’ mortgages and ‘consolidation’ loans.
But now money is getting tighter across the globe. The main reason that investors have stopped “underpricing risk”, as Mr Knight puts it, in the last few weeks is because all that money flooding the system is drying up.
The threat of rising interest rates in Japan, in particular, has speculative investors on the run. We published a piece from Martin Spring on this topic in yesterday’s Money Morning – if you missed it, you can read it here: The truth behind the stock market slump?
So the BIS has admitted that central banks have taken their eyes off the ball of asset prices. So what’s the solution? Simple of course – give central banks the powers to fiddle with more economic levers.
“The BIS called for the use of weapons such as regulatory powers to curb the build-up of ‘credit-financed imbalances’ shown by bubbles in the prices of assets such as houses,” reports The Times.
This doesn’t sound like a great idea to us. Not only would we have a layer of politicians interfering in markets, we would also gain a layer of bankers conducting economic experiments as well. Given the amount of trouble central banks have caused with the few tools they already have, wouldn’t it be better to reduce their powers, rather than increase them?
Earlier this year we posted a piece questioning whether we need central banks at all. You may not agree with its conclusions – but it’s certainly thought-provoking. You can read it by clicking here: Do we really need central banks?
Turning to the wider markets…
The FTSE 100 ended lower, down 28 points at 5,652 on Tuesday. Miners were among the main losers as copper prices fell after a report revealed that world copper supply exceeded demand during the first three months of 2006. Xstrata fell 3% to £19.04. For a full market report, see: London market close
Over in continental Europe, the Paris Cac 40 shed 30 points to 4,771, while the German Dax fell 55 to close at 5,459.
Across the Atlantic, US stocks slumped as investors remained nervous ahead of Thursday’s interest rate decision. News that sales of previously-owned US homes fell 1.2% in May also didn’t help after hopes had been raised by unexpectedly high new home sales during the same month. The Dow Jones Industrial Average fell 120 to 10,924, while the S&P 500 closed 11 points lower at 1,239. The tech-heavy Nasdaq fell 33 to 2,100.
The Wall Street sell-off hung over Asian stock markets. The Nikkei 225 dived 285 points to 14,886. Exporters such as Honda were among the main fallers.
This morning, oil was higher in New York, trading at around $72.15 a barrel. Brent crude was up too, trading at around $71.30.
Meanwhile, spot gold was lower, trading at around $581 an ounce. Silver was also lower, slipping to $10.26 an ounce.
And in the UK this morning, music company EMI has rejected a £2.5bn offer from US rival Warner Music.
And our two recommended articles for today…
Why savings matter
– US consumers are currently spending more than they earn. This is helping to prop up global growth – but it can’t last forever, says Jeremy Batstone at Charles Stanley, especially not now that monetary policy around the world is tightening. To find out how savings ratios impact on stock markets, click here: Why savings matter
Is the US housing market correcting or crashing?
– Many financial commentators believe the US housing market is set for a soft landing. But the property market bears all the classic hallmarks of a bubble, says Kevin Duffy of Bearing Asset Management. To find out why today’s ‘housing vital signs look less than encouraging’, see: Is the US housing market correcting or crashing?