By Larry Elliott at The Guardian
The People’s Bank of China was preparing to spring a surprise while President Xi Jinping was taking a selfie with Manchester City star Sergio Aguero. On Friday, the central bank in the world’s second-biggest economy cut the cost of borrowingfor the sixth time in a year.
This move has implications, none of them especially cheery despite the knee-jerk increase in share prices that followed. Those investors who thought the announcement in Beijing was a big buy signal should ask themselves whether this was a sign of strength or a sign of weakness.
It is worth noting that the interest rate move came just days after China released official figures showing that the economy’s annual growth rate had slowed down in the third quarter, but only to a still healthy looking 6.9%. After all the stock market turmoil in August, that was a strong performance and it had the desired effect of reassuring markets that the authorities were in control of the planned rebalancing of the economy towards more modest but better quality growth.
But as all commentators know, China’s official figures are not worth the paper they are written on. The fact that interest rates were cut four days after the latest growth data was released underlines the point. Danny Gabay at Fathom thinks China’s real growth rate is 3%, and the rate cut late on Friday night suggests he is right.
The good news for the PBoC is it has plenty of scope to cut rates further from their current level of 4.35% should the economy not respond to the stimulus provided. Unlike other central banks, it has not already cut the official cost of borrowing to zero (and in some cases below zero). The bad news is that it might need all the leeway it has available. That’s certainly the view of Gerard Lyons, a China expert at Standard Chartered before he became economic adviser to Boris Johnson. Lyons thinks that sooner or later China will join the rest of the central bank pack.
But it is not just in China that things are looking a bit dicey. On the day before the PBoC cut rates, the European Central Bank dropped the broadest of hints that in December it will announce new growth-boosting measures for the eurozone. Mario Draghi, the ECB’s president, has options. He could cut the ECB’s deposit rate, already -0.2%, still further and thus penalise banks that want to park money with the central bank. More likely, though, the ECB will turn to its version of quantitative easing and increase its bond-buying programme from the current €60bn (£43bn) a month.
Japan is also poised to provide more stimulus later this week when official figures are likely to show the economy back in recession. As with the ECB, a central aim of the policy is to secure a competitive advantage by bearing down on the exchange rate. But if the yen and the euro are weakening, something else has to be strengthening, and the upshot will be that the US dollar will rise.
With the US economy showing signs of slowing, the Federal Reserve, America’s central bank, will put on ice any plans to raise interest rates, for fear that this will drive the dollar even higher.
So what’s the problem? China, Japan and the eurozone are all easing policy. The US is going to delay tightening policy. More stimulus equals stronger growth and fends off the threat of deflation. That’s got to be good, hasn’t it?
Well, only up to a point. Problem number one is that by deliberately weakening their exchange rates, countries are stealing growth from each other. Central banks insist that this does not represent a return to the competitive devaluations and protectionism of the 1930s, but it is starting to look awfully like it.
Problem number two is that the monetary stimulus is becoming less and less effective over time. There are two main channels through which QE operates. One is through the exchange rate, but the policy doesn’t work if all countries want a cheaper currency at once. Then, as the weakness of global trade testifies, it is simply robbing Peter to pay Paul.
The other channel is through long-term interest rates, which are linked to the price of bonds. When central banks buy bonds, they reduce the available supply and drive up the price. Interest rates (the yield) on bonds move in the opposite direction to the price, so a higher price means borrowing is cheaper for businesses, households and governments.
But when bond yields are already at historic lows, it is hard to drive them much lower even with large dollops of QE. In Keynes’s immortal words, central banks are pushing on a piece of string.
Nor is that the end of it. Charlie Bean, until recently deputy governor of the Bank of England, is the co-author of anew report that looks at the impact of persistently low interest rates.
It concludes there is a danger that periods when interest rates are stuck at zero are likely to become more frequent, resulting in a greater reliance on unconventional measures such as QE that are subject to diminishing returns.
“Second, and possibly more importantly, a world of persistently low interest rates may be more prone to generating a leveraged ‘reach for yield’ by investors and speculative asset-price boom-busts.”
The current vogue is for macro-prudential policies – attempts to prevent bubbles from developing in specific asset markets, such as housing. But the paper makes the reasonable point that the macro-prudential approach – yet to be tried in crisis conditions – might not work. There is, therefore, a risk that tighter monetary policy in the form of higher interest rates will have to deployed in order to deal with the problems that monetary policy has created in the first place.
Bean and his co-authors conclude that the maxing out of monetary policy puts a higher value on fiscal policy – the use of tax and spending – and structural reform. There is certainly a strong case for the former, particularly in the form of higher public investment, but at present this is not the way the ideological wind is blowing. The wrong sort of structural reform, such as weakening collective bargaining, will depress aggregate demand and end up doing more harm than good.
This is a time for caution. The fact that central banks feel the need to provide more stimulus more than six years into a recovery is not a reason to load up on shares or, indeed, any risky assets. Rather, it is a sign of trouble ahead. If the global economy requires a fresh growth boost, it means that an already feeble recovery is waning. If it doesn’t, it means there is a heightened risk of a new financial crash or higher inflation.