Thursday, March 5, 2009

Central banks race to zero (2)

The Bank of England threw in the towel today, so to speak, by lowering its target interest rate to 0.5% and, by promising to buy tons of bonds, to effectively join the Fed in implementing "quantitative easing." The European Central Bank came close to joining the party by cutting its rate to 1.5%. Three out of the world's major central banks are now effectively targeting a zero interest rate, and the European and Canadian (0.75%) central banks are not far behind.

This says a lot about how powerful is the world's urge to hold money instead of other assets right now. Even when they offer to lend money at close to a zero interest rates, central banks can't find enough takers. Rather than borrow money, financial markets in aggregate are trying to do the opposite by deleveraging (i.e., by selling other assets to raise cash). By implementing quantitative easing, central banks are in a sense offering to help people deleverage directly, by buying the securities that financial markets are trying to sell. We could say that this makes them the "buyer of last resort."

This is not really about central banks pumping in money in an effort to get their economies moving again, it is about trying to accommodate a collective rush to the exits. Monetary policy has never been a good tool for stimulating growth, since its main purpose is to regulate inflation. So we shouldn't be too concerned that all this "easy money" hasn't yet resulted in a stronger growth or significantly higher inflation. By being the buyers of last resort, central banks are playing an effective role in alleviating this crisis of confidence, and that is helping markets to heal.

At some point the world's demand for money will satiated. Central banks will then have to reverse course, while running the risk of reacting too late and thus oversupplying the world with money for awhile.


dave said...

I found this article very interesting thought you might too

Scott Grannis said...

I remember reading that memo years ago. If Jude were still with us, I think he would say that we are not in a deflation, because gold is $925/oz. He would say we are more likely in a contraction, and that monetary policy can't really fix that. Trying to fix it just makes gold go higher. What we need is a fiscal fix, like lowering taxes. Instead, Obama wants to move in the opposite direction by raising taxes. So monetary policy and fiscal policy are both making mistakes and this is aggravating the situation.

I would generally agree with this, but I would also note that the Fed is helping to resolve the stresses that have accumulated as a result of all the mistakes. That means the Fed is in a really tough situation, and there are no easy solutions.

dave said...

I agree that we are in a contraction, and again that we are making both monetary and Fiscal mistakes.

I think the various bailouts will tend to prolong the problem, not end it.

Cabodog said...

The market seems to be saying things aren't working. Either that, or there are some incredible bargains out there.