Market Insights: Central banks have lost the plot

This week’s annual meeting of global central bankers at Jackson Hole comes at a time when investors are beginning to question the wisdom of ongoing extreme monetary stimulus. Contrary to many critics, however, my concern is not that these measures have not worked. Instead, I maintain they’re simply not needed, as the global economy is as good as might be expected once allowance is made for slowing potential growth and falling commodity prices. To my mind, the far bigger global risk now is the impact of persistent misguided extreme monetary measures on financial stability.

Global growth has been OK

Global economic growth in recent years has been commonly perceived as disappointing, which in turn has been attributed to the scale of the financial shock endured in 2008. Indeed, focusing on developed economies – which are most responsible for today’s extreme monetary measures – annual GDP growth among members of the Organisation for Economic Cooperation and Development (OECD) averaged 1.7% p.a. in the five years to end-2015, compared with 2.8% p.a. in the 5 years to end-2007.

Yet around half of this growth slowdown has reflected a slowing in working-age population growth (from 0.8% p.a. to 0.2% p.a.), with the other half reflecting weaker growth in GDP per working-age person (i.e weak productivity). In other words, most of the slowdown in growth among developed economies since the financial crisis has reflected weaker potential growth.

Indeed, as seen in the chart below, economic growth across the developed world in recent years appears to have been above potential, as evident from the fact that unemployment rates have trended down. The unemployment rate averaged across the OECD has declined from a peak of 10.4% in the March quarter of 2010 to 6.4% by the March quarter of 2016. Only in Europe is the unemployment rate still clearly above pre-financial crisis lows, but it has also still fallen notably in recent years.

UNEMPLOYMENT RATES IN SELECTED OECD ECONOMIES

Source:OECD

Even the Reserve Bank of Australia has acknowledged decent growth in the developed world, noting in its August Statement on Monetary Policy “labour market conditions in most advanced economies have continued to improve and a number of these economies are close to full employment.” Crisis, what crisis?

Global inflation is not perilously low

Along with reasonably good growth above potential in recent years, the argument that inflation across the developed world is perilously low – suggesting we are at risk of a deflationary slump – also does not stand up to scrutiny.

As seen in the chart below, headline consumer price inflation across the OECD is relatively low at present, with prices up 0.9% in the 12 months to end-June 2016 – compared with an average since 2004 of 2.1% p.a.. But most of this drop in inflation reflects the decline in commodity prices in recent years. Indeed, in the year to end-June 2016, core OECD consumer prices (i.e excluding food and energy prices) were up 1.8% – equal to their (relatively stable) average since 2004.

As seen in the chart below, core CPI inflation rates in both Japan and the United States are currently above their respective averages since 2004, whereas in the Euro-zone inflation remains modestly below average.

All up, especially in the case of the United States and Japan, the case for extra-ordinary monetary stimulus seems very weak. Economic growth in recent years has been above potential in both economies and their respective labour markets are now close to fully employed. Excluding declines in food and energy prices, core consumer price inflation in both countries is actually above their long-run average levels.

In the case of the Euro-zone, growth has also been above potential, though the unemployment rate across the region still appears elevated compared to pre-financial crisis levels. It’s also the case that core inflation in the Euro-zone is below average. In this regard, Europe seems to warrant somewhat more monetary stimulus than that of Japan and the United States, but even in Europe the case for extreme monetary measures seems weak – in view of the fact that unempoyment is trending down, and because core inflation is both still comfortably above zero (at 0.9% in the year to June 2016) and only modestly below its 1.4% p.a. average since 2004.

Financial instability is the biggest risk

Against the backdrop of reasonable post-financial crisis performance among developed economies in recent years – allowing for declines in both potential growth and commodity prices – it is staggering that key policy interest rates are still near-zero in many regions, and central banks have massively enlarged their balance sheets through aggressive buying of financial assets. As seen in the charts below, Japan is the most extreme example, with the Bank of Japan’s balance sheet now almost equal to that of Japanese GDP even though core inflation is above average and the economy is close to full employment!

The impact of these extreme monetary measures are highly distortionary for the global economy. As seen in the charts below, sovereign 10-year government bond yields are now at their lowest levels in at least a century, and price-earnings-valuations across many markets are approaching levels that have not been sustained since the dotcom bubble period earlier last decade.

The great worry is that the bubble in bond yields now appears to be slowly but surely flowing through into equity valuations. Unless global central banks change course – and correctly recognise the reasons for apparently low global growth and inflation have little to do with deficient demand – they are at risk of creating yet another boom-bust cycle in asset prices within the next year or so.

We’re heading the wrong way and it’s time to turn back.

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