Thursday, January 8, 2009

Central banks race to zero

This chart shows the target rates for the world's four major central banks. Note how the recent economic airpocket has hit every major economy in the world, prompting central banks to slash their interest rate targets in unprecedented fashion. The Bank of England today cut its rate to 1.5%, the lowest rate since the bank was established more than three centuries ago.

Note also how the Fed, the Big Kahuna of central banks, has had a much more volatile interest rate policy than the ECB; it is not surprising, therefore, that the Euro has been more stable and generally stronger than the dollar. As for the Bank of Japan, rates have been hugging zero ever since the late 1980s/early 1990s, when it committed the biggest deflationary policy mistake since the Great Depression.

Central banks and their policy actions are extremely important not only to economies but also to investors. You should never underestimate the power of central banks to achieve their objectives. Right now they all want to avoid deflation, and they are trying very hard. Monetary policy is not very effective at managing economic growth, but it can be very effective at influencing inflation. Today's very low interest rates don't guarantee a quick or robust recovery, but they do promise a quick end to deflationary concerns.

Should they achieve their objective of avoiding deflation, then Treasury yields will soon after be revealed to have been in a "bubble" state.

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