The global financial markets have increasingly become an Alice in Wonderland world. The sight of stolid central bankers going in for quantitative easing to expressly boost asset markets has become familiar by now, losing its capacity to shock and awe. But what about their decision to boldly go where no central banker has gone before, with negative interest rates as their vehicle?
Japanese central bank chief Haruhiko Kuroda surprised everyone by cutting his benchmark interest rate to -0.1% last month, which means that banks will have to pay for the privilege of keeping their deposits with the central bank. The European Central Bank has a negative interest rate of 0.3%. The central banks of Switzerland and Denmark have negative interest rates. And the Swedish central bank recently cut its policy rate to -0.5% from -0.35%, despite decent GDP growth in Sweden and a housing bubble in the making. Kuroda was merely trying to make sure Japan didn’t lose out in an increasingly desperate race to depreciate currencies to try and boost growth.
Why have central banks been forced into such reckless policies? The simple fact is that eight years after the financial crisis erupted and despite unprecedented stimulus from central banks, growth is still anaemic. Lewis Carroll described it perfectly in Through the Looking Glass: “Well, in our country," said Alice, still panting a little, “you’d generally get to somewhere else—if you run very fast for a long time, as we’ve been doing." “A slow sort of country!" said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!" Negative interest rates, hope central banks, will allow the economy to run twice as fast.
But here’s the rub. Since 29 January, when Kuroda announced negative interest rates, the Japanese yen has appreciated against the dollar. The USD-JPY rate, which was around 121 before the announcement, is now around 113, after dipping below 112 briefly at the height of the panic in the markets last week. Instead of depreciating, the yen has appreciated. One reason could be the markets are worried about the impact negative interest rates will have, particularly on banks. Another could be the perception of the yen as a safe haven, God knows why, which led to money fleeing back to Japan as a result of the nervousness in Asian markets. With such unintended consequences, negative interest rates could be the sword on which Kuroda-san commits hara-kiri. Or will he make them even more negative?
Look what happened after the Fed rate hike on 16 December 2015. That should have strengthened the US dollar and led to higher bond yields. The US dollar index did spike up to 99.6 a day after the hike, but now it’s down to 95.5, a level not seen since the end of October last year. The US 10-year government bond yield, which was around 2.29% on 16 December, is now at 1.7%.
Are global central banks losing the plot? In Carroll’s Through the Looking Glass, Humpty Dumpty’s confidence in all the King’s men to put him together if he fell off the wall was grossly misplaced. Could it be that the confidence in central banks is similarly out of place?
Is it really the case that the central banks’ response to the financial crisis has resulted in a huge asset bubble without the underlying economic growth to support it? An answer to the last question was recently given by John P. Hussman, president of the Hussman Investment Trust and one of the few who predicted the financial crisis. Hussman’s latest weekly newsletter refers to a 2014 research paper by economists Cynthia Xu and Fan Dora Xia which concluded, ‘“In the absence of expansionary monetary policy, in December 2013, the unemployment rate would be 0.13% higher... the industrial production index would have been 101.0 rather than 101.8... housing starts would be 11,000 lower." In other words, expansionary monetary policy has had a very feeble response on the real economy, although asset prices have been boosted strongly. The markets are now adjusting to that reality.
In a recent speech, Claudio Borio, the Bank for International Settlements’ Head of the Monetary and Economic Department, said that global debt levels continue to be too high, productivity growth is too low and policy room for manoeuvre too limited. His presentation warns “Recent developments are just the latest scene in this movie: Turning financial cycles in EMEs (emerging market economies) and tightening external financial conditions; Risk of vicious circles, serious financial distress and weakness spreading to ROW (rest of the world)." His final point: “We cannot afford to rely on the current debt-fuelled growth model any longer." True, but the big question is: how then does the world economy get out of the rabbit hole?
Borio’s presentation is titled: “The movie plays on: A lens for viewing the global economy". The financial crisis is seen as a movie, the effects of which are still playing out. The title of the film could well be, Alice’s Adventures in Financial Wonderland.
Manas Chakravarty looks at trends and issues in the financial markets. Comments are welcome at email@example.com