- Global asset prices have been propped up for the last five years by easy monetary policy. Recent turbulence in financial markets highlights the dilemma facing policymakers as they contemplate taking away the punchbowl of cheap money.
- On 22nd May, US Federal Reserve's Chairman, Ben Bernanke, sent shock waves through equity markets by suggesting the Fed might slow its programme of quantitative easing (QE), which has involved huge purchases of US government bonds. Mr Bernanke reiterated the message in mid-June, causing a further sell off in equity and bond markets.
- Markets worry that an end to Fed bond buying will reduce their price and force up interest rates on bonds. The result will be less liquidity in the system and higher interest rates.
- The change of course in US policy has coincided with a growing cash crunch in China, caused by a tightening of policy designed to restrain reckless lending.
- The shift of policy in the US and China aims to take the steam out of overheated asset markets.
- Policymakers also want to get markets used to the idea that ultra-loose monetary policy is not here to stay. As Richard Fisher, a member of the Federal Reserve's interest rate setting committee, put it last week, it makes "sense to socialise the idea that quantitative easing is not a one-way street".
- Markets have reacted strongly to the prospect of an end to loose monetary policy. Chinese equities fell by 17% between 22nd May and the low on 23rd June. US Treasury bonds lost 4% of their value, taking interest rates on US bonds to the highest level in almost two years. Interest rates on US 30-year mortgages have risen from 3.5% to 4.5% in just a month.
- The effects have not been confined to the US and China. Equities have fallen everywhere, with the UK's FTSE100 down 12% from its May highs. Market expectations for UK base rates at the end of 2016 rose 100 basis points between the start of May and late June. Government bonds in safe markets like Germany and riskier ones like Greece, have sold off. Investors last week withdrew a record $23.3 billion from global bond funds. Emerging markets have been hard hit by the change in sentiment with the South African rand at a five-year low against the dollar and the Indian rupee close to a 20-year low.
- While policymakers wanted to dampen the excesses caused by easy monetary policy, they do not like panics and they certainly do not want to kill the patient. As the Fed's Mr Fisher put it last week, "I don't want to go from Wild Turkey to cold turkey overnight".
- So, in the last few days, central banks have struck a more soothing tone. The Federal Reserve has sought to calm markets by saying that the pace at which QE is slowed, or tapered, depends on data. Officials point out that Mr. Bernanke said that the Fed would end its asset purchases only if US unemployment falls below 7% (the current rate is 7.6%).
- Last Tuesday, the outgoing Bank of England, Sir Mervyn King, said markets had "jumped the gun" in thinking that Central Banks were close to raising interest rates. And the People's Bank of China has said it will provide funding support to any banks that face temporary funding shortages.
- The soothing words have duly worked their magic, helping bolster equities last week.
- The dilemma for central banks is that the premature ending of QE risks renewed recession. But if they wait too long, they risk creating asset bubbles and inflation.
- Policymakers hope that by signalling shifts in policy well in advance they can ensure a gradual and orderly adjustment to reduced monetary stimulus.
- Our guess is that, in finessing this task, central banks are likely to be more concerned about growth than quashing asset bubbles. The ghost that seems to haunt policymakers is that of the Great Depression of the 1930s, not the great inflation of the 1970s.
- Central bankers know that the premature withdrawal of monetary stimulus in the US triggered a double-dip recession in 1937-38. The Bank of Japan made the same mistake in 2006.
- Most recessions are preceded by heady growth, plentiful credit and soaring asset prices. The challenge for central banks today is a very old one - to get growth going without sowing the seeds of the next credit boom.
MARKETS & NEWS
UK's FTSE 100 ended the week up 1.6%.
Here are some recent news stories that caught our eye as reflecting key economic themes:
KEY THEMES
- UK retailer Sports Direct is in talks with Tesco to take excess space in some of Tesco's largest stores
- The BBC has tapped financial markets for the first time to raise £160 million to finance expansion by BBC Worldwide
- Mortgage approvals by UK banks have risen by almost 25% over the last year
- Inward investment to the UK rose by 22% last year
- Issuance of convertible bonds in the US is rising at the fastest rate since the financial crisis, with corporates attracted by the low financing costs
- Research by the FT shows that the average pay of top bankers in the US and Europe dropped by 10% last year
- Investors pulled $23.7bn from US bond funds in the 4 weeks to the end of June - the largest withdrawals since October 2008, in anticipation of a slowing of America's quantitative easing programme
- The Bank of England warned that financial institutions needed to "ensure that they have a richer understanding of the scale of risks from abrupt shifts in interest rates or from mispriced risk"
- US house prices recorded their largest year-on-year rise in 7 years in April, with sales of new houses rising to a near 5 year high in May
- US consumer confidence rose in May to its highest level in more than 5 years
- The price of gold fell to its lowest level in nearly 3 years, putting the metal on track for its largest quarterly fall since 1971
- Haringey council, in London, banned access to payday loan companies' websites at all council buildings in a bid to protect residents from "the pitfalls of excessive interest rates"
- UK household saving rates fell to 4.2% of disposable income in Q1 2013, the lowest level since Q1 2009, due to squeezed incomes and rising prices
- Estimates of Britain's shale gas reserves more than doubled after higher-than-expected reserves were found in Bowland Shale, which covers 11 counties in northern and central England
- Global cyber-crime is a greater concern for UK bank chiefs than the eurozone crisis, according to Andrew Haldane - the Bank of England's director of financial stability
- Eurozone finance ministers agreed new "bail-in" guidelines for bank rescues, to ensure losses are born by bank shareholders, bondholders and some large depositors, and not taxpayers
- French president Francois Hollande said that France may miss its 3.7% annual deficit target by the end of the year if growth remained as weak as it currently is
- Co-operative businesses have reached an all-time high according to a report by Co-operatives UK, with 15.4 million members, an increase of 36% since 2008
- PayPal announced that it is working with the SETI Institute, which explores evidence of life in the universe, to plan how commerce might function in space, with the advent of space tourism
- Japanese mobile operator SoftBank acquired a 78% stake in US-firm Sprint Nextel for $21.6bn, the largest overseas takeover by a Japanese company
- Danish health and beauty retailer Matas became the first Danish company to launch an IPO in 2 years, in the 3rd largest European listing of the year
- A Japanese pensioner is suing the national broadcaster NHK for "emotional distress", blaming the broadcaster's use of words borrowed from English, which can often be impossible to translate in to Japan's phonic structure - lost in translation.
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