The QE along with the ultra low rates, as a loose monetary policy did what it had to do, during the crisis and also in the immediate aftermath, but the temporary measure also made the market somewhat irrational, and then came a time when markets got addicted to it, and kept on going higher regardless of the underlying fundamentals. And what we thought was a large Airbus 380 flying at 40,000 feet turned out to be an Airbus 318, so now, when our perception is changing, we find ourselves stuck, because, we know that an Airbus 318 is, simply not big enough to carry, and then keep the world economy flying at 40,000 feet, and also there is a realisation in some parts of the market that the Airbus 318 was never really flying at 40,000 feet. But the problem is, the central bankers, who kept the plane flying are now running out pages in the instruction manual.
So the central bankers in the developed world will need to find a way to get themselves unstuck. Low rates coupled with low inflation is not what most central banks in the developed world were expecting, and now they find themselves STUCK. In the QE era world, low interest rate environment isn’t necessarily all good and positive for the real economy, because the incentive to chase better returns leads to misallocation of capital. The asset price inflation that came about mainly from the misallocation of capital has more or less peaked, the fundamentals of the real economy were never that strong to drive the record level asset pricing. Easy money supply from QE was the main factor that created asset inflation.
Today, globally , the overall inflationary pressure in the real economy is somewhat subdued, and the central banks in the emerging economies are also lowering the rates. And this creates a very interesting problem for the central banks going forward especially in the UK and the US. The way, I see it is, the world economy is now starting to sail blind ( more or less ), and I must say, I’ve got my fingers crossed.
By waiting for an opportune time to raise rates, the central banks in the developed world have started the work of undoing all the previous good work that was done during the crisis, and in it’s immediate aftermath. Water in the ocean has to travel in a wave, and a still ocean is always a sign of something disruptive that’s probably on the way. So, we are getting stuck, by design, QE and the low rates as a part of the ultra loose monetary policy were supposed to be temporary measures, but for whatever reasons, it became the norm, and now, the markets have simply got addicted to the ” new temporary “.
The FED as well as the BOE will rightly say that there is no change in circumstances that demands a rate hike, in fact, the slowing world demands that the rates remains low for an extended period. And the markets are now starting to position themselves accordingly. But there is no guarantee that a low interest rate environment globally, will do the world any good, even when the developing world is also seeing a subdued inflationary environment. In my own view, the central banks can and should try to influence the flow of capital. It is what is required, and there is almost no real harm to the global economy if the FED was to raise rates by 25 bps, and by not doing that we run the risk of making what was supposed to be a temporary status quo, the ” new permanent “. If we continue with the existing ” status quo ” then there is a serious risk that markets will remain irrational and therefore volatile, and both will have damaging implications on the real economy. Take for example, the recent upswing in commodity prices , the price movement is not based on the assumptions that the fundamentals of the global economy is improving, or going to improve dramatically. In fact, it isn’t, and if we look at the recent growth projection of IMF, and also the overall inflation environment around the world, then it will be quite difficult to find a sound economic argument for the price movement upwards, but in my own view, I believe, the commodity market is moving up because of the realisation that rates will remain low. So the misallocation of capital as well as the distortion of market reality will therefore continue.
The benefits of QE as well as low rates was somewhat limited to the real economy, as a large part of the capital didn’t really flow into the real economy. And most data suggests that financial investors were in fact the main beneficiaries. The financial investors saw no real benefit, in terms of overall return of investing in the real economy , so a large part of the capital went into inflating the pricing of the financial assets for obvious reasons. Real economy isn’t designed to create high double digit returns in a very short period of time. So financial investors chasing quick and substantial return saw no incentive of committing capital to the large part of the real economy. But the hope was, especially from the central banks that at some point, the money will flow into the real economy. Having said that, QE and the low rates more or less served a their good purpose, but the central banks to a large extent failed in their attempt to channel the flow of capital where it could have been utilised to create growth in the real economy.
And if we are to rely on historical evidence, most available data suggests that when the financial markets starts growing bigger and faster, it is generally at the expense of hurting the real economy, and more often than not, it leads to a crisis.
The FED as well as BOE will need to change the ” status quo ” or in other words tweak the current market dynamics, a bit. You need a positive and a negative polarity to create the flow of current. The wind flows, when you have a high and a low pressure environment. And to keep a plane flying, you need to have a strong flow of air across both the wings. An economy like most planes requires two pilots, and so far, the central bankers have taken the lead in flying the plane, and they have done a good job especially in the absence of a strong leadership from various governments, but now, it’s time for the governments to play their role. So far the governments have failed to deliver on the important reforms that was badly needed. We have had sound bites coming out from various pockets of the governments as well as the political class in general, but the real lasting reforms aren’t quite visible yet. Blaming the financial markets and making the banks, a villain, is now an old story. The fact is, without the central banks taking the lead, the governments won’t really have an economy to talk about today. But there is a limit to what can be achieved through monetary policy alone, and I have always suspected that at some point, the central bankers will run out of tricks, and the limits of monetary policy tools will be tested and exposed. And it looks like that’s where we are today.
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