Christophe Bernard joined Vontobel 2012 as Chief Strategist. He is also Chairman of the company’s investment committee.More Articles
Through their monopoly on setting interest rates, central banks can help lift people’s wealth or cause economic depression. Over the past decade, they have been in giving mode for fear of mismanaging the latest financial crisis. The global economy and financial markets have been happy to feast on the gifts provided by Ben Bernanke and his colleagues. The days of this free lunch are now drawing to a close, but so far, only the U.S. Federal Reserve has started to raise interest rates. We expect the European Central Bank and the Bank of Japan to follow suit but at a snail’s pace.
Despite the emergence of modern central banking after the First World War 100 years ago, developed economies have been subject to periods of boom and bust. Therefore, the judgement that historians have passed on central bankers has sometimes been harsh. With the benefit of hindsight, the expression “policy error” has often been applied to qualify their decisions or lack thereof.
Probably the most blatant policy error was the U.S. Federal Reserve’s (Fed) inappropriate reaction during the Great Depression in the 1930s. As panic set in after “Black Monday” in October 1929, the Fed did not act as a lender of last resort but watched a significant number of banks collapse. By failing to prevent successive waves of bank runs, it contributed to triggering a pronounced economic depression with U.S. real GDP falling by 26 percent (from 1929 to 1933), unemployment spiking to 25 percent (in 1933) and the general level of prices retreating by 26 percent, measured from peak to trough (from January 1930 to March 1933).
These shocking events taught central bankers and politicians a lesson. The acid test came in 2008, when the bankruptcy of U.S. investment bank Lehman Brothers threatened to bring the global financial system down. At that time, the U.S. administration acted decisively to support the banks (through the so-called TARP program1) and the Fed provided nearly unlimited liquidity via massive purchases of bonds (“quantitative easing”). The decisive reaction from the Fed, followed by other major central banks, most probably prevented a slide into depression. Even so, the consequences of the latest financial crises were severe. For instance, U.S. GDP fell 4.2 percent (from its peak in the fourth quarter of 2007 to its trough in the second quarter of 2009), unemployment hit 10 percent (in October 2009) and inflation readings slumped from 5.6 percent in July 2008 to -2.1 percent in July 2009 (see chart 1).
Chart 1: U.S. Great Depression-era economic slump was much more severe than that during the recent crisis
Index 1929=100 and 2007=100
Source: Bureau of Economic Analysis, Thomson Reuters Datastream, Vontobel
We have no doubt the world’s central bankers have won top marks for springing into action. Today, the global economy is growing in a synchronized manner, unemployment has diminished substantially and banks are much more robust. Clearly, this comes at a price. The flip side of the central banks’ extraordinary efforts is rising debt levels across most countries, de-facto expropriation of savers through zero or even negative interest rates and the concerns that asset prices are again being blown up beyond proportion.
Much academic research has been invested in central banks’ core competence – the setting of interest rates. One easy to understand result is the so-called Taylor rule, named after U.S. economist John Taylor (also see Special topic section from page 8). The rule, which tries to establish what policy rate allows for potential GDP growth without triggering an acceleration in inflation, indicates that the Fed, despite a series of rate hikes, is still too “dovish” (see chart 2). This holds true for the European Central Bank (ECB) as well.
Chart 2: Taylor rule shows that U.S. monetary policy was frequently either too “dovish” or too “hawkish”
Source: U.S. Federal Reserve, Bureau of Economic Analysis, Congressional Budget Office, Bureau of Labor Statistics, Thomson Reuters Datastream, Vontobel
Central bankers are currently in a bind. While it is natural to err on the side of caution, flooding the economy and financial markets with liquidity can have serious side effects. For instance, missing the right moment to stem the tide can create asset price bubbles in the future, whose bursting will in turn create financial instability. However, hiking key interest rates too early can nip the much-needed economic recovery in the bud. A fine example of the challenges for central banks is the so-called dotcom bubble that collapsed around the turn of the millennium. In the aftermath of the equity market downturn that followed, the Fed under chairman Alan Greenspan avoided a deeper recession in 2001-2002 by cutting interest rates aggressively. Yet the U.S. monetary policy has remained too loose for too long, fueling a real estate bubble which turned out to be the root cause for the great financial crisis in 2008-2009.
We believe that Janet Yellen, the current Fed chairwoman, is aware of such pitfalls. She has already referred to frothy valuations in parts of the equity and credit markets. That being said, the pressure not to tighten “prematurely” is equally immense. The job of a central banker is truly a hard one...
The current environment remains characterized by reasonably strong global economic growth, buoyant corporate earnings and still accommodative monetary policies. We remain moderately overweight in risky assets as elevated valuations do not allow for a more bullish stance, in our opinion. Beyond the well-known geopolitical risks, the tightening of monetary policy beyond consensus expectations represents the most credible threat to the current bull run. This is the reason we will closely monitor incoming data to gauge when central bankers will start to take away the punch bowl in earnest. Within our central scenario, this is a matter for the second half of next year and not for now, but we better stay vigilant.
1 Troubled Asset Relief Program