Central Banks Losing Control?

A couple articles at Der Speigel which are of interest. First, it appears that some of Europe is facing possible deflation, and the European Central Bank (ECB) is preparing monetary policy with an eye towards staving it off. This first article segues into the second article, which is about the central banks nearing the limits of their ability to influence financial markets.

Once every six weeks, the most powerful players in the global economy meet on the 18th floor of an ugly office building near the train station in the Swiss city of Basel. The group includes United States Federal Reserve Chair Janet Yellen and her counterpart at the European Central Bank (ECB), Mario Draghi, along with 16 other top monetary policy officials from Beijing, Frankfurt, Paris and elsewhere.

The attendees spend almost two hours exchanging views in a debate chaired by Bank of Mexico Governor Agustín Carstens. Waiters serve an exquisite meal and expensive wine as the central bankers talk about the economy, growth and market prices. No one keeps minutes, but the world's most influential money managers are convinced that the meetings help expand their knowledge in important ways. "We learn what makes our counterparts tick," says one attendee. [Ed: i.e., they conspire against the public].

These closed-door meetings, which are held on Sunday evenings, have a long tradition. But ever since many central banks lowered their interest rates to almost zero, bought up sovereign debt and rescued banks, a new, critical undertone has crept into the dinner conversations. Monetary experts from emerging economies complain that the measures taken by Europeans and Americans are pushing unwanted speculative money their way. Western central bankers say they have come under growing political pressure. And recently, when the host of the meetings -- head of the Basel-based Bank for International Settlements Jaime Caruana -- speaks in one of his rare public appearances, he talks about "chronic post-crisis weakness" and "risk." Monetary institutions, says Caruana, are at "serious risk of exhausting the policy room for manoeuver over time."

These are unusual words, especially now that the world's central bankers, five years after the Lehman crash, are more powerful than ever. They set interest rates and control the money supply, oversee governments and banks and, like Bank of England Governor Mark Carney, are treated a bit like movie stars by the public.

To an extent unprecedented in postwar history, monetary watchdogs -- who are not elected and are usually independent of their countries' governments -- determine what happens in politics and on the markets. They are the new "masters of the universe." Yet their internal discussions on the effects of their power do not give the impression of resounding success. Growth is limping along in the world's major economies; banks, households and governments are deeply in debt; and the bankers' so-called unconventional monetary policy is running up against its limits everywhere.

The article goes on to discuss some of the concerns expressed by these masters of the financial world. For instance, speaking of the Fed's intervention after 2008, the article notes:

The rescue effort was ultimately successful, and yet the patient still hasn't yet fully recovered. The economy is only slowly gaining steam and many factories are not operating at full capacity. This has prompted some of Fisher's counterparts on the Fed Board of Governors to advocate pumping even more money into the economy. Fisher, on the other hand, finds it disconcerting that the Fed has already bought up sovereign bonds and mortgage-backed securities worth $18 trillion -- a sum comparable to a quarter of the entire US government debt -- with little effect.

That's because much of the money flowing into the financial sector did not reach the private sector in the form of credit, as central bankers had expected. Instead, banks are pumping it into the stock market, where prices have reached dizzying highs in recent months. Values are now approaching levels similar to those before Black Friday in 1929 and the bursting of the dotcom bubble 70 years later.

Part of the blame lies with politicians in Washington, who are unable to agree on the federal budget. Companies don't invest as long as they don't know how their tax burden will look in the coming years, and as long as they don't invest, the economy will remain sluggish. The central bank's fuel isn't reaching the engine, Fisher warns, adding that it is bubbling in a giant gas tank that could explode at any moment.

 And this about matching a graph of the business cycle (the real economy) versus the financial cycle:

It reflects fluctuations in the financial sector, for which Borio uses the growth in loans and real estate prices as an indicator. There are only minor fluctuations in the cycle until well into the 1980s, because the capital markets were still highly regulated and nationally isolated until then.

But then, as deregulation and globalization took hold, the financial sector becomes increasingly separated from the real economy, following the self-fueling logic of speculation, under which a bull market feeds a bull market and a bear market a bear market.

The fluctuations in this economic parallel universe reach massive dimensions in the 1990s. The only problem is that monetary watchdogs weren't watching. They remained exclusively oriented toward the ups and downs of the real economy, in keeping with the prevailing geopolitical doctrine: When prices rise during a recovery, central banks raise interest rates to avert inflation. When the economy declines, they reduce the cost of borrowing.

What they overlooked is that their decisions inadvertently influence the fluctuations in the financial markets. In 1987, for example, the Fed reduced interest rates following a market crash. Its aim was to avert a recession, but instead it stimulated an unhealthy boom in the housing market, which led to a sharp decline in prices soon afterwards and the collapse of hundreds of savings banks.

A decade later, it was the terrorist attacks of Sept. 11, 2001 that prompted the Fed to flood the markets with money. But that time the bubble didn't just build in the real estate market, but also in the lending and banking sector, ultimately leading to the crash of the century and the ensuing financial crisis. In attempting to control the economy, the central bankers created "a monster," as former German President Horst Köhler once put it. They have become hostage to the financial industry.

 Read the whole thing.