Muddy Waters – Central Banks, interest rates and the need for fiscal policy

9 September 2015

JR Max Wheel


Central Banks appear to be in a total quandry about interest rates with the result that we have had a ludicrous situation of near zero interest rates for seven years in the US and UK. Whilst ZIRP rates and QE were supposed to trigger a return to economic normality, they have not done so. The growth and employment statistics have improved in both countries, but something has broken in the present model. It is not just zero hours contracts and a drift to self-employment, growth in production is weak and uncertain in most advanced countries and much of this antedates the now evident problems in China and emerging markets. The fear factor is that the underlying economies are too weak to sustain a change in policy. That way we remain in thrall like an addict and that normalization is somehow not possible!


If you are an Austrian school economist you might take comfort from the fact that this all results from a massive misallocation of resources and hence no real surprise at all. Interest rates are and meant to be fundamental signals; that they are not thanks is in no small measure thanks to Central Bank policy manoeuvres and QE which goes a long way to explain the disconnect. Whilst few would argue that in the immediate aftermath of 2008 massive intervention and stimulus was needed, it has now become embedded; this is unhealthy. Any attempt to unwind QE or to raise rates has resulted in behaviour like the 2013 US “taper tantrum”, throwing markets into reverse gear. Persistent low-interest rates discourages savings and blows asset bubbles – the most obvious ones being the property and until very recently stock markets: meantime asset managers are seeking yield even via the re-generation of securitized assets based on inflated property prices. Have we learned nothing? It seems not.


The banks have also retreated substantially from traditional intermediation, itself a result of weakening incentives to lend and potentially damaging to balance sheets, this often leaves SME companies in difficulties, whilst institutional investors like pension funds face increasing mismatches between liabilities and weak returns on assets. None of this looks in the least bit helpful to a sustained return to a normalized economy.


The commentariat continues to assert that QE has not/will not bring forth inflation, but this is because central banks do not count asset price inflation, (typically equities and property) gains in their calculations: this is an error that needs addressing. It is not the dog that didn’t bark, rather the one that was ignored. The big news though has been oil prices and the price decline of any major factor input would logically contain inflation, but for how long? Monetary policies pursued by central banks are often accompanied by long lags, so maybe we should be looking out say 2 years before sensing signs. Clearly the oil price will have asymmetric effects on economies depending  on whether they are importers or exporters of energy.


The BIS latest annual report makes for required reading, for anyone mystified by the current malaise. It can be found here: It calculates that between Dec 2015 and May 2015 some US$ 2 trillion of LT sovereign debt is trading at negative yields. This is clearly unsustainable, yet at the same time sovereign debt levels continue to rise. A further problem is the erratic movements in currencies, the dollar and euro have moved quite violently in opposite directions, and the Chinese have engineered a decline in the value of the RMB. The global nature of the US $ in trade is a rapid transmission mechanism to other and especially emerging markets, not helped by the collapse of the commodities “super-cycle” .

What the BIS gets absolutely right is that monetary policy alone cannot succeed in bringing about a normalized economy, that much is blindingly obvious, there needs to be a proper role for fiscal policies and to avoid building up additional and unwelcome problems, we had better address the imbalances – a good starting point would be a move to begin the process of raising interest rates and reining in QE. The latter has only worked fitfully at best and production and investment will only recover when it is able to judge from an appropriate benchmark. Managing this will have to be communicated to markets a whole lot better than the shall we, shan’t we approach of the Fed or specious “forward guidance”  approach of the Bank of England.