The perils of doing too much

Central banks have been recruited to stave off economic disaster but they may have been forced into overplaying their hand.

The global financial crisis has propelled central banks into prominent roles in fighting off recession while politicians have been slow to act.  Being the last remaining stalwart against economic disaster, central banks had to go further and do more than would have ever been previously conceivable due to their limited range of policies.  Even though the efforts of central banks have some effect in keeping the global economy afloat, the jury is still out with regard to the distortions left behind by the actions of central banks as well as their new roles as backstops for the global economy.

Most central banks have been given independence over the past few decades due to the notion that this will aid them in their central goal of reigning in inflation.  The theory behind this is that politicians would be tempted to use the tools of monetary policy – setting interest rates and the level of money supply – to boost economic growth and their re-election chances to the long term detriment of the economy.  So independent economists at central banks were given the reigns of monetary policy and a target for inflation of typically around 2% to ensure that a safe pair of hands would be in charge.  The typical cycle of monetary policy involved interest rates rising during periods of strong economic expansion to keep lending in check while a weaker economy prompted cuts to interest rates in order to make borrowing easier. 

The global financial crisis that struck in 2008 involved what could be deemed to be a perfect storm.  Politicians had got caught up in the bubbly state of the economy and government spending got out of hand backed by tax revenues that were later found to be just a temporary fill-up.  This was not just confined to a few countries but the Bush administration in the US, the Labour government in Britain, and many countries in Europe were running large budget deficits at a time when common sense would have suggested putting money away during the good times.  So when the banks got themselves into trouble and required help from tax payers, government finances were already stretched and there was nothing left in the coffers to bail out the economy. 

A crisis of confidence hit the global economy with spending by consumers and investment by companies being cut back due to the chronic uncertainty of whether the banking sector was going to collapse.  Your Neighbourhood Economist would argue, with a good dose of hindsight, that the typical Keynesian policies of an increase in government spending would have been the best response to the global slowdown with government making up for the shortfall in demand from elsewhere.  Government spending could have made up for the shortfall in demand, but the mismanagement of government finances meant that this option was not available.

Monetary policy was always going to be a struggle (a bit of hindsight coming in useful here too) as the activities of the central banks during recessions, such as boosting lending, are generally transmitted through the financial system.  Yet, banks everywhere were fighting for their own survival instead of being concerned about the tinkering of central banks in the background.  The weak translation of monetary policy into positive effects on the actual economy has resulted in the extent of the actions of the central banks having to be ramped up to have an effect.  The most obvious example of this is the recent announcement by the Japanese central bank that it plans to double the money supply in Japan which would be beyond belief even just a few years ago (for more, see All bets are ON). 

Even though the worst seems to be over, central banks are still in a difficult situation in terms of getting out of the role of being the guarantors of the economy.  The massive scale of their involvement in the economy will make an orderly retreat fiendishly difficult due to possible economic hiccups in the future and uncertainty over how the economy will respond.  Even if this Herculean task is pulled off with minimal problems, a new precedent has been set where central banks will now ride to the rescue if the economy goes bad. 

This situation is made worse by politicians who have shown themselves to only look short-term in their focus when dealing with such problems as the Eurozone crisis in Europe or the fiscal cliff in the US.  The expanding responsibilities of central banks may find them overextending themselves to the detriment of the good work they have achieved so far such as keeping a lid on inflation.  Central banks have overachieved during the global financial crisis considering their initial remit but should not have to be relied on to save the day.  Economists are not meant to be super heroes.

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

Caution – Windy Road Ahead

Trends in the stock market are hard to spot at the best of times but upcoming changes to monetary policy will add a few extra twists and turns.

Trying to work out the right time to buy or sell shares is like driving at night with a busted headlight – only some of the road ahead is visible and it is best to proceed with caution.  Evidence suggests that even the so-called experts struggle to negotiate the markets better than anyone else.  Everything from nutty dictators in North Korea to the latest iPhone can throw the markets into disarray.  The task of investing in stocks has been made even more difficult due to extra funds in the financial system stemming from central banks everywhere printing money.  The actions of the central banks has given shares an extra boost but the resulting gains are expected to fade with more cash likely to be less forthcoming as the global economy improves.  With monetary policy now dominating movements in the stock market, the prospect of changes by central banks are likely to leave investors hanging on the edge of their seats.

The basic premise of shares in a company is that it entitles the owner to a portion of the profits in that company.  The value of shares will rise or fall depending on the company’s ability to generate profits in the future.  While profits also rely on circumstances at each individual company, it is the state of the economy in which companies operates that tends to dictate the direction of the stock market.  So it may seem like somewhat of an anomaly that some stock markets such as in the US are hitting record highs at a time when the outlook for the global economy is so dismal.  The reason behind all this is monetary policy. 

Central banks were quick to slash interest rates to close to zero with the onset of the global financial crisis, but when the low interest rates were having little effect in terms of the prescribed goal of boosting lending, a new policy of quantitative easing was adopted.  Central banks started to print money and use this to buy bonds with the hope of making borrowing even cheaper.  Yet in spite of all of these efforts, consumers and companies have been stuck in a cautious mood and loathe to part with their cash which they have stashed away instead. 

The surplus funds end up being invested in assets such as bonds and stocks.  Bonds would be the preferred investment due to being a safer bet amid these turbulent times, but with central banks spending billions buying up bonds (which increases prices and reduces returns), the meagre pay-out from bonds has seen funds flow instead into the stock market.  The extent of these cash flows is such that it is vagaries of monetary policy that have come to dominate the direction of share prices.  The underlying health of the economy only registers to the extent to which it has an effect on the bond buying of central banks and has created a paradoxical situation where bad news regarding the economy is good for shares as weak economic growth translates to continued action by central banks.

The return of growth in the global economy may help to cushion any weakness in share prices as the central banks wind down their operations.  In theory, steady economic growth ensures that corporate profits increase over time, and thus, the value of stocks is typically on an upward trend.  But with the possibility of ups and downs in the global economy, shares may end up being overpriced depending on the extent of a potential correction in the market due to the change in monetary policy.  The potential for a correction in the stock markets makes it tricky to call whether it is a good time to buy or sell with the added uncertainty likely to make for a bumpy ride if you have the stomach for it. 

Close your eyes and hope for the best

Some advice for how to ride out the upcoming twists and turns in the markets.

Your Neighbourhood Economist tries to remain impartial when writing, but like many people, has a certain amount invested in the topics that are mentioned on this blog.  For most of us, it is our employment which can make us vulnerable to the ups and downs of the global economy.  But for some who have a bit stashed away here and there, putting any extra cash to good use is a tricky predicament at this time.  It seems to be like riding a roller coaster in the dark – hence the title of this article – is the best investment advice that Your Neighbourhood Economist could come up with and here is why.

Investment options can be categorised into two types (or a mixture of both) – safe or risky.  With many countries in the developed world still suffering a hangover from the aftermath of the global financial crisis, it would seem as if the clever move would be to go down the safe route.  But the safe option - bonds - has been jumped on by so many investors that returns from bonds have hit record lows in many places, such as debt from countries like Germany or the UK, which are seen as refuges from the turmoil elsewhere. Even the banks with their own problems are paying out higher interest rates than the more prudent options in the bond market.

With such a meagre pay-off from playing it safe, money has been migrating to riskier options with higher returns with shares being the obvious example of a riskier investment.  As such, some of the indices for the big stock markets such as the Dow Jones in the US have hit record highs.  This may seem a bit strange considering the doom and gloom surrounding the outlook for the global economy but it is a phenomenon which has been engineered by central banks across the globe.  Their policy of printing loads of cash has been targeting increased lending and a boost to the prices of assets that you and I might hold such as real estate or stocks.  This increase in asset prices is meant to help us open up our wallets and be more willing to spend (a phenomenon referred to as the “wealth effect”) despite the lingering possibility of job losses and sluggish increases in wages. 

There is a fatal flaw in this scenario that makes investing in this seemingly booming market for stocks even more of a risk.  Central banks will have to shut off the flow of cash sometime.  The main concern for central banks is inflation and keeping it at a sufficiently low level.  But more money, when people actually spend it, leads to higher prices which will be the result of the central bank policies once economic growth returns in earnest.  So the flow of extra cash from central banks which has pumped up share prices will end at some point in time over the next few years.

The timing all depends on the state of the economy in different countries with the Federal Reserve in the US already signalling that it will soon taper off its buying of bonds depending on a continued fall in unemployment.  The European Central Bank has its monetary policy on hold for the moment as the economic situation in Europe gradually improves but may act if another crisis kicks off, while the central bank in Japan has ramped up its monetary policy with the stagnating economy seemingly impervious to previous bouts of monetary stimuli.

This puts potential investors on a scary part of the metaphorical roller coaster ride of investing in the stock market.  There has been a big drop in the market with the financial crisis and the upward turn as share prices bottomed out, but where to next?  To complicate matters, it is the cash coming out of the central banks more than the actual state of the economy that seems to dictate share prices.  This has led to a paradoxical situation where the stock market can fall due to positive news on the economy as robust economic growth would prompt central banks to shut off the flow of cash.  

The result is a lot of twists and turns ahead as the market players try to assess the future of monetary policy, the direction of the global economy, and how other investors will react amongst all of this.  What is bound to ensue is a lot of screaming over both the good and bad.  But with few other easy investment options available, there may be little else to do but invest in stocks, close your eyes and hope for the best.

All bets are ON

Both the government in Japan and many investors are betting on the power of monetary policy but it is not much more than a roll of the dice.

Japan has long suffered at the hands of the same problems that have hit Europe, and as a result, the central bank in Japan has also been a pioneer of the loose monetary policy which has since become the mainstream response to such problems.  The recently-elected Japanese government has upped the stakes with a further round of monetary policy which goes far beyond anything previously proposed.  Investors too have been putting their money on the line in the hope that the new measures will bring about a long awaited revival in the Japanese economy.  However, the limited effect of monetary policy so far in the aftermath of the global financial crisis suggests that this is nothing more than a gamble in order to avoid some tougher choices.

A massive financial bubble in Japan in the late 1980s has resulted in two decades of economic stagnation due to the now common culprits of the overpriced real estate market, overwhelming government debt, and a lack of sources of growth.  The interest rates have been set close to zero for more than a decade while the Bank of Japan has also pumped money into the economy.  Successive Japanese governments have held back from making the necessary reforms to help the economy unwind the imbalances built up during the boom years and instead amassed debt equal to 230% of GDP, rather than deal with the problems that the country is facing. 

The new wager on monetary policy involves a doubling of the money supply as part of measures to achieve inflation of around 2% in two years.  However, the new monetary measures will just be another stalling tactic if not combined with other policies which help to kick start business activities.  The immediate effect of printing more money is that the value of the yen has dropped from below Y80 to over Y100 against the US$.  A weaker yen is a boon for many of Japan’s manufacturing giants who have large exporting operations.  The boost to their profits along with hopes for a new beginning for the Japanese economy has prompted many investors to throw in their lot with the Japanese government and the stock market surging by almost 70% in 6 months until a recent setback.

Yet this is symptomatic of actions by governments and investors across the globe.  Booms and busts in any economy involve considerable transformation as businesses adjust to new realities and government can either try to facilitate this process of companies adapting, which helps the economy become more productive over the long term, or stand up against forces of inevitable change to ease the short term pain.  Prior faith in monetary policy has enabled governments to believe that central banks have the power to restart economic growth with less hardship.  But new engines of growth are not given the scope to expand and monetary policy is relied upon more and more to prop up the economy. And using monetary policy to weaken a currency and boost exports will only work as long as the country’s central bank is expanding their money supply faster than anywhere else (for more on this, see Currency Wars).

This complicates the process of selecting investments with a layer of politics being overlapped with normal considerations of business profits and economic performance.  And with monetary policy taking a more dominant role in the strength of the economy, investors find it necessary to track the actions of central banks rather than just corporate activities and economic indicators.  As such, investors are second guessing what the central banks will do while the central banks take their best shot at what they think will be good for the economy. 

It is questionable whether the current set of policies that are commonly employed by central banks have been of much use so it is a considerable punt by the Japanese government to put all its money on more of the same despite any consensus which suggests otherwise.  But it is a way of being seen to be proactive while actually avoiding backing more difficult choices which are more likely to pay off in the long term.  And with bets in the stock market following the government line, this will multiply the losers and add to the woes of those who actually try to sort out the mess in the future.