Tuesday, 29 December 2009

Central banks are not putting the foot on the brake

The signs are multiplying that the central banks are readying themselves for mopping up excess liquidity added to the market over the past 15months. Obviously it has a tendency to make the financial markets nervous. I do not think that there is any reason to fear that the central banks will steal the punch bowl right now where the party is in full swing. They are simply preparing how to move the monetary policy from being "extremely accommodative" to just "very accommodative". Once that is achieved, there will still be several notches down to the "neutral" or even "somewhat restrictive". I do not believe that the financial markets will receive any shocks from that side for quite a while.
There has been a lot of talk about the impending hyperinflation. I just do not get it. Of course some vestiges of old monetarist theories can be used to say that if you print money, you will have inflation. This kind of thinking belies the complexity of the current situation. First, there is still a substantial output gap, i.e. difference between what the economies could produce and what they actually do produce. We are nowhere near closing this gap. And in order for the "too much money chasing too few goods" mechanism to work, one would have to assume that output cannot be increased in case demand increases. That is hardly the situation right now. Be sure that the OECD and the IMF will have ample time to warn about it happening. And those institutions are not known for being quick off the mark.

Another issue is has to do with the transmission mechanism from banks to the broader public. There is no direct connection between the liquidity being put at the disposal of the banks and the liquidity available to the broader public. It would be the case if the banks had used the facilities to increase lending. They haven't, and as a result the multiplier effect between the two kinds of money has been breaking down over the past year. This is clearly witnessed by the fact that there has been an upsurge in short term bond issues by companies. In other words, banks use the available liquidity to bolster their own capital by playing the steep government yield curve and companies are increasingly seeking funding outside the banking sector. That does not in any way indicate that the private sector is flooded in liquidity. Of course this situation will normalise over time, but there is still quite a way to go before it happens.

This could indicate that the zero interest rate policy is failing in one aspect, putting cheap liquidity at the disposal of companies in order for them to operate normally or even to resume investing. But the ZIRP is working efficiently in another way. The asset price reflation since March 2009 has made us all feel better. Our pension accounts are not bombed out, our security holdings have recovered a good deal of what they lost, property prices are stabilising, and in general we are not as scared any more. Demand is picking up and corporate managers who hit the panic button a year ago are beginning to see the light at the end of the tunnel.

I do not believe that the central banks are ready to hit the brakes anytime soon. If not for anything else, then because of the health of the banking sector. We have all heard of the high earnings and the ludicrous bonuses. One important element of this development is that the banks were given wide-ranging possibilities of hiding bad loans as when the mark-to-market principle was suspended. But hiding bad loans will not mean that they go away. As the number of corporate bankruptcies has sky-rocketed worldwide, it is safe to assume that delinquent loans are on the rise. They will have to be dealt with later, hopefully when the banks have capitalised themselves better – partly courtesy of the tax payer.

And then there is the Basel II. A lot of technical stuff published by the BIS last week, it essentially contains new and stricter requirements to the capitalisation of banks going forward. In the light of the experiences in the past year, it does not sound unreasonable. However, it means that it will take banks longer to return to "normal" health. It also makes it unlikely that central banks will be quick to revert to a restrictive monetary policy.

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