In introducing the latest quarterly report from the Bank for International Settlements (BIS), Claudio Borio, head of the bank's monetary and economic department, bemoaned the way financial markets had come to depend on central banks' every word and deed, thereby complicating any return to more normal interest rates.
With the Federal Open Market Committee due to pronounce on the US policy interest rate on Thursday, his point could not have been more timely.
It will also have struck a chord with those investors who are weary of trying to make sense of a world where markets have been systematically rigged by central bankers.
There is much, too, that is compelling about the wider BIS view, which asserts that we are addressing the post-crisis economic challenge with yet more of the same – loose monetary policy and more debt – and that monetary policy cannot solve the solvency problem implicit in the debt build-up. But does that critique amount to a strong enough reason to raise rates now?
Certainly there is a more interesting case here for a rate rise than the one offered by those who cry wolf about inflation in a world singularly short of inflationary pressure.
And much of what the BIS economists have to say is beyond dispute. Over a long period of time, United States monetary policy has operated on an asymmetric basis whereby the Federal Reserve loosens in response to market collapses but fails to restrain market euphoria.
The result has been ever greater credit-fuelled boom-and-bust cycles accompanied by ever-increasing debt.
More generally, rock-bottom interest rates encourage what Austrian school economists call malinvestment in suboptimal projects, support for zombie companies, reduced pressure for structural reform and poor productivity performance.
Yet in some ways that appears to be a better description today of China, at the end of its debt-fuelled investment boom and property bubble, or even the euro zone, than the US. Since the underpowered US recovery picked up we have seen nothing like the egregious misallocation of capital that took place before 2007. Credit conditions have not been wildly out of hand, even if lending standards and borrowing covenants have recently deteriorated.
As for malinvestment, it is striking how little impact quantitative easing has had on capital investment in the non-financial corporate sector. Negligible nominal interest rates appear not to have persuaded many industrialists to lower their hurdle rates of return. Expectations of future demand for their products and distorted executive incentives appear more powerful factors in investment decision-making than financial conditions. In fact, the impact of quantitative easing has been much more striking in the housing market.
And yet, and yet. I am beginning to think that malinvestment simply takes different forms in the US.
Take share buybacks. Investors like them, partly because they think, with academic evidence in support, that stock markets reward companies that buy their own shares, relative to those that do not. But companies have been following the central bankers in rigging the market, pushing equity prices up to heady levels that may not be validated by economic growth. The “evidence” of putative value creation is short-term noise. The reality is that companies are buying shares expensively at the cost of increased leverage, which amounts to a misallocation of capital.
Then there is the resurgence in mergers and acquisitions, which are now running at levels reminiscent of 2007.
If we know anything about M&A it is that managers are too easily carried away by the thrill of the chase, resulting in the notorious winners’ curse.
When you bear in mind that $3 trillion of deals have been agreed across the world since January, much of it in the US, the scope for capital misallocation is once again large.
On the BIS view it is safer to raise rates now than to wait, in order to pre-empt a worse bust later. Yet with credit conditions giving only modest cause for concern, it strikes me that the greater risk lies in prematurely killing off a recovery that is not quite self-sustaining and being left with the unenviable deflationary dilemma faced by Japan.
Trying to revive an economy with a minimal interest rate toolkit would mean yet more quantitative easing and more potential financial instability. In truth, the monetary policy dilemma is impossible. But at this juncture the risks in raising rates look far greater than in staying put. – Copyright The Financial Times Limited 2015