Has Mario Draghi’s triumph in the eurozone made central bankers too cocky?
Last summer, the head of the European Central Bank managed to superglue the eurozone together with barely anything more than three little words: “whatever it takes.”
It seemed like magic. And now every central banker wants to repeat the trick.
Last week, new Bank of England boss Mark Carney told markets they were wrong to expect higher interest rates any time soon. Presumably, he was expecting them to act like good little boys and girls and run out to buy more bonds.
Trouble is, they’ve done the opposite. They’re now betting on rates rising even more quickly than they’d expected before he opened his mouth.
Could we be approaching the end of the cult of the central banker? And what would that mean for your money?
Being a central banker is about to get a lot harder
Central bankers have had an easy job over the past few years. Make that decades.
I realise if Ben Bernanke or Sir Mervyn King were reading this, they’d have spat their coffee out all over their keyboards in indignation by now. But it’s true.
A central banker’s role boils down to hitting one of two buttons. Hit the green button that pumps more money into the economy (whether through cutting interest rates or buying longer-term bonds). Or hit the red one to take it out (by raising rates, or selling bonds).
People like cheap credit. So hitting the green button is always the most popular choice. And everyone likes to be popular. So central banks have spent most of their time keeping monetary policy as loose as they possibly can.
It’s been particularly easy since the credit crisis kicked off. The whole world has been convinced that the global economy is on the verge of dropping off a cliff. So the obvious route has been to make monetary policy as loose as possible.
Where it starts to get tricky is when you have to change direction. And this is why Mark Carney and Ben Bernanke are suddenly running into trouble.
Carney’s mission impossible
Let’s recap for a moment. Britain is piled high with debt. You can argue about the precise causes and the precise impact of that. But whatever the reasons, that’s where we are, and the government’s aim is to inflate our way out.
That means ‘financial repression’ – keeping interest rates below inflation. It also means reflating the house price bubble. Our banks’ balance sheets (particularly the ones owned by the taxpayer) were destroyed in large part by the property bust. Boosting prices again is one of the easiest ways to get them out from underwater.
The trouble is, the government is walking a tightrope. It’s one thing to want higher house prices. Those are a sure-fire vote-winner, as the recent rapid turnaround in the polls demonstrates.
However, a big chunk of the Tories’ natural voting constituency (more so than Labour’s certainly) cares about things like the returns on their savings, or how they’ll pay for their retirement given pitiful annuity rates and the ongoing attack on private pensions. Inflation is something that worries them, understandably.
So George Osborne really doesn’t want to let Carney turn around and admit that the inflation target simply isn’t a priority right now. We saw this in this year’s Budget. Despite hints that the Bank of England’s remit would change radically, there was no real shift.
So Carney’s mission (which he chose to accept, once the pay packet was big enough) is damn near impossible: “Keep interest rates low, give us a nice house price boom, but pretend that you still care about inflation.”
These things aren’t compatible. It’s one thing to promise that you’ll keep rates low when everyone still feels that the economy is a hair’s breadth away from recession or deflationary depression. They’ll believe that.
It’s quite another to promise low rates forever when everyone is convinced – due to a steroid-injected housing market – that the good times are back with a vengeance.
That’s why no one believes Carney. The trouble is, there are things that the central bank can promise with credibility, and there are things that it can’t.
As a central bank, you can turn around and target one thing. You could target the ten-year gilt rate for example. You could say: “I don’t care what happens to inflation or anything else. I will keep the ten-year gilt rate at 2% if I have to pump out more money than the Weimar guild of printers.”
That’s an achievable promise. As long as markets believe you are crazy enough to do it.
But you can’t promise two things. You can’t promise to keep rates low, and to keep inflation low too. You can guarantee one or the other. But you can’t guarantee both.
That’s the problem for Carney. He didn’t really make a promise. He made a prediction. He warned markets that they were getting ahead of themselves in pricing in higher interest rates. His aim was to assure investors that monetary policy would remain loose for a long time to come.
But he also said that this might change, if inflation rose above a certain level, or employment recovered to a certain point. Given that the Bank of England is terrible at making predictions, markets rightfully didn’t believe him.
That’s why the price of gilts is falling, and yields are rising. That’s why the cost of borrowing for the UK is going up.
‘Peak’ central banker
This is where the choices get difficult. Carney is going to have to come down on one side or another -either inflation is the priority, or keeping interest rates low is what matters.
Martin Sandhu, writing in the Financial Times, argues that Carney shouldn’t fret about inflation. “More activism is needed – whether in the form of yet lower (or negative) short-term interest rates, more purchases of gilts, and, perhaps, private debt, or outright targeting of specific market rates.” Much as I disagree with Sandhu’s prescription, I suspect it’s what we’ll get.
But there’s a danger here. Financial repression works best if it’s subtle. If investors start to believe that the central bank genuinely doesn’t care about inflation – if Carney has to make that choice more explicit – then either the bond market or sterling as a currency will suffer.
How is another round of quantitative easing going to look when most of the population is convinced by headlines proclaiming record house prices? When the central bank is busy arguing that the economy is too weak to take higher interest rates, but the government is electioneering on the back of a raging recovery?
Finally, central bankers are being faced with tough choices. We might soon find out which global economies are strong enough to take the pain of higher rates, and which ones aren’t. That doesn’t bode well for Britain.
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