Policy-easing doesn't give central banks a free bet
Last week saw an array of comments from various central bankers trigger further strong gains in financial markets, with bond yields in Europe reaching all-time lows and the main stock market in the US hitting all-time highs.
Both the US Federal Reserve and ECB gave strong indications that policy easing is in the pipeline, possibly as early as next month.
Meanwhile, the Bank of England appears to have canned plans for any near-term hikes.
The Bank of Japan is set to continue easing policy via quantitative easing, or QE, while another rate cut seems likely from the Reserve Bank of Australia very soon.
With the global economy performing well in the first quarter of this year, central banks are getting out in front in terms of loosening policy to ward off risks of a significant weakening in global growth.
It is also worth remembering, in this regard, that in many of the major economies, unemployment has fallen to multi-decade lows and they now enjoy full employment.
Certainly, any rate cuts from the Fed would seem to be a pre-emptive strike, as it left its growth and inflation forecasts largely unchanged from three months earlier at last week’s policy meeting. GDP is seen as growing at around 2% in the next couple of years, which is pretty solid for an economy that is at full employment.
Rate cuts, then, in the US are an insurance policy to ensure the expansion is sustained, which is more or less what the Fed itself said last week. It expects to take them back at a later stage, as the Fed sees rates returning back up to their current levels by 2021.
The ECB, on the other hand, has been mainly spooked by falling inflationary expectations. The ECB president Mario Draghi emphasised in his comments last week that the ECB may need to provide further stimulus to get inflation to move up towards its 2% medium-term target.
Inflation in the eurozone has remained persistently below target in recent years. It is currently at just 1.2%.
Market expectations about what the eurozone inflation rate will be in the future have been falling this year as the economy loses momentum.
The five-year-on-five-year measure of forward inflation expectations - where inflation is expected to be on a 5-10 year horizon, or in the period 2024-2029 - has fallen to around 1.2% recently, from circa 1.7% last year.
One has to wonder, though, how some additional monetary easing by the ECB will see it achieve its 2% inflation target, when already very loose monetary conditions have failed to do so in recent years.
Indeed, it could be argued that the 2% target is too high to be met in this era of super-low inflation.
An overly accommodative monetary policy comprising quite negative interest rates and a large scale QE bond purchasing programme is not a free bet for a central bank, even at a time of very low inflation.
It brings its own risks and can be quite distortionary.
The downsides can include inflated asset values, market imbalances and distortions, as well as the mispricing of risk.
It also severely penalises savers and creates problems for pension funds, insurers and the banking system.
Furthermore, it leaves monetary policy neutered in terms of responding to a sharp weakening in activity.
Central banks must be hoping that monetary policy will have become at least somewhat normalised before the current economic cycle ends.
The ultimate irony would be if negative side-effects of very loose monetary policies were a catalyst for the next downturn in the global economy.
