When the Bank for International Settlements’ Claudio Borio described the institution’s thoughts on prolonged low interest rates this week, he referred to the old joke about a tourist in need of directions. When he asks a local for them, he’s told, “If I were you, I wouldn’t start from here.”
Borio’s point was that economies have been too reliant on easy money for too long and that not only will it not have the intended effect, it will have serious negative consequences.
Unfortunately, this is a very bad time to have to make the call. Even policymakers that have been outspoken about the worryingly distortive effect persistent low interest rates are having, such as the International Monetary Fund, are now warning the US Federal Reserve to hold off on hiking rates with inflation low and volatility high.
This is a caution that seems to have heeded, as the Federal Reserve decided that Thursday was not the time to start ratcheting rates for the first time since I was allowed to drink beer (I’m from the US).
Regardless of the Fed’s decision, there is going to be pain . Emerging market economies are starting to look weak, and if nothing else has been learned from years of suppressed rates and quantitative easing strategies, we know that central banks do not operate in national vacuums any longer.
Unsustainable asset prices
On the other hand, the Fed could be staring at unsustainable increases in asset prices for a while longer. While it is arguable that monetary easing has not had some of its desired effects — inflation is still low — it has clearly helped to fuel equity prices, for example, and the fear that equities are highly overvalued is clearly implied in that market’s volatility. A hot topic in US securitization is whether there is already a bubble brewing in commercial real estate.
Central banks have led us through a decade of unchartered economic waters, and so it is little surprise that there are great risks whichever way the Fed voted.
It doesn’t help that markets are losing faith in the power of central banks. Royal Bank of Scotland polled 150 institutional investors and found that two-thirds say central bankers are losing credibility and options to fight deflationary pressures.
The Fed’s problem is thus a Catch-22 situation: keep rates low and risk accelerating imbalances and perhaps never hitting inflation and growth targets — not to mention risk the embarrassment of having to back off its heavily implied intent to raise rates. But raise them at the next opportunity, and the Fed will be doing so into a very fragile global economic scenario.
One is tempted to argue that at least an attempt at macroprudential regulation to curb asset prices and debt build-up should be made before pulling the rates trigger. It may not work — measures taken in the UK and Sweden have had small success — but then again, no one’s completely sure how or if monetary easing can be really effective at achieving long term financial stability, either.
But Fed chair Janet Yellen has herself espoused the idea that macroprudential regulation and supervision should “play the primary role” in promoting financial stability, as she said in a 2014 speech at the IMF. And in May, the heads of a handful of major financial institutions themselves endorsed the use of macroprudential tools to be broadly applied across the financial sector, to address overheating in asset classes like real estate lending.
With the fragility of the global recovery in mind, maybe it’s best to start putting serious work into building a macroprudential arsenal before hiking rates.
The Fed is in an unenviable position, to say the least. Over the coming months Janet Yellen, having inherited easy money from Bernanke, will make or break the theory that has been the basis for the entire post-crisis era of central banking, so far. And correctly timing a rate hike is like slamming the brakes at 120mph to stop on a dime.
Another joke that pertains to the situation, then: A man is driving around unknown territory looking for a small town. Let’s call the town “Timing-on- Raterise ”. His map tells him he’s right on top of it, but after getting lost several times and taking many a wrong turn, the driver spies a local on the side of a road and screeches to a stop to ask where, exactly, Timing-on- Raterise actually is?
“Don’t you move a goddamned inch,” says the local.
Let’s hope the Fed is that lucky when it makes its call.