One innocent explanation for the extraordinary bounce back in global equity markets in the second quarter is that investors have concluded that the worst of the pandemic is over and that recovery is within reach.
A less innocent — but all too plausible — alternative reading is that investors now believe central banks will exercise complete control over asset prices for the foreseeable future. In other words, the categorical imperative of policymakers doing “whatever it takes” to counter the current crisis could ensure a lasting decoupling of equity prices from ailing economies.
Lending support to this latter view is the growing conviction in markets that the US Federal Reserve may now move to a policy of yield curve control. That would mean following the Bank of Japan in capping borrowing costs by targeting a longer term interest rate and buying enough bonds to stop yields rising above that level.
It would amount to financial repression of the kind operated by the Fed in and after World War II, as a means of managing exceptionally high levels of government debt. By keeping nominal rates of interest constantly below the nominal growth in gross domestic product, the debt-to-GDP ratio can be reduced over time. But the question is whether this would work today.
Extravagant spending supported by such measures would require markets to have enormous patience with soaring government debt. When patience runs out, the traditional policy response is to resort to capital controls to prevent outflows to countries where debt looks more sustainable. Yet with the US, custodian of the world’s dominant reserve currency, this would pose extraordinary, maybe insurmountable, difficulties. There could be investor strikes in fixed-income of the kind that disrupted markets in the 1970s.
There would also be malign side effects of keeping borrowing costs artificially low. Among them would be maintaining life support for zombie companies that earn less than they need to cover interest payments. Since the pandemic hit, many such companies now survive thanks to direct central bank largesse. The resulting misallocation of capital damages productivity and thus economic growth.
The morally hazardous consequence of ongoing ultra-low interest rates would be a continuing rise in private sector debt even as the public sector leverage ratio is declining. And to the extent that investors discount future corporate earnings using these artificially low rates to calculate equity market valuations today, those current valuations risk being artificially high.
This approach to economic management would create a perception in markets of an enduring reduction in systemic risk, as liquidity would be so abundant. The mispricing of assets that has been a feature of capital markets over the past 20 years — as central banks have bought more and more bonds — would then become yet more extreme, as would the search for yield regardless of risk.
A further complication is the adverse impact of ultra-low rates on bank profitability, though this is less of a problem for the US — where the banks have relatively high returns on equity — than for Europe and Japan.
The biggest challenge for the central banks would be the potential threat to their credibility. In a recent paper for the Brookings Institution, Sage Belz and David Wessel point out that yield curve control requires the central bank to commit to keep interest rates low over a set timeframe. This is how it can help encourage spending and investment. But it also means, they add, that the central bank runs the risk of letting inflation overheat while holding to its promise.
If overheating does occur the central bank may have to choose between abandoning its promise or failing to hold to its stated inflation objective — “both bad options in terms of its credibility with the public”, as the Brookings writers put it. Certainly, a decision not to tighten policy in response to above-target inflation would lead to accusations that central banking independence was a mere fig leaf for policies designed to keep politicians sweet.
A pick-up in inflation is a far more probable outcome than markets currently allow. It is, moreover, part of the solution to countries’ excessive debt burdens.
The likelihood is that greater resort to direct monetary financing of spiralling government deficits will have a powerful impact on inflation, which will also be encouraged as the labour force gains more bargaining power and governments come under pressure to reward key workers.
Working in the shadow of the pandemic and the last financial crisis, politicians and central bankers may feel that they have had little alternative to fiscal expansion and financial repression. But in doing so, they have thrown caution to the wind. The prevalent belief that ever-increasing debt is manageable, because servicing costs are low, will ultimately prove toxic.
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