The problem with creating money is that the practice holds down bond yields until it doesn’t, and then it sends them through the roof.
At least that’s what I think will happen. It’s hard to know since none of us have lived through a time like this when the world’s central banks are flooding markets with liquidity and low interest rates.
The Federal Reserve’s QEs, 1 and 2, as well as the pledge on January 25 to keep interest rates at zero until late 2014, have helped keep bond yields at around 2% and produced a lucrative carry trade for banks that has kept the wolf from their doors and fuelled a reasonably healthy recovery in the US economy, creating 150,000-200,000 jobs a month.
The European Central Bank’s LTRO, 1 and 2, has helped hold down bond yields on Europe’s periphery and avoid a bond market contagion by handing the banks cheap money for a lucrative carry trade, although Spain’s bond yields started to break out last week anyway.
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And the Bank of England’s QE, the greatest of them all, has helped keep the City of London alive through, yes, a lucrative bank carry trade.
It is a policy for a time of deleveraging, when deflation is the enemy, not inflation, and maybe the central banks will time their exit from their “accommodative” stance just right – just before the world starts to favour credit once more.
More likely they will face the inevitable consequence of free money: rising prices of goods and services.
The Reserve Bank of Australia showed its wariness about this last Tuesday, when it decided to look at another inflation report before once again lowering interest rates, even as it admitted that growth was weaker than expected.
But Australia is an island in a sea of concern the other way: as the RBA tries to ensure that inflation comes down to 2%, the Fed, ECB and Bank of England are trying to get it up to 2%, and make sure it stays there.
But there is a tendency to mis-define the problem. Is the deflation they are fighting good or bad deflation? Are they in fact fighting the 2008 war, instead of 2012 one?
Bad deflation is where a shortage of credit causes inventories of goods and assets to be unfinanceable and they have to be sold, driving prices lower. That’s called a debt deflation.
Good deflation is where costs of production fall through technology or globalisation and competition ensures these lower costs are passed on through lower prices. As Jim Grant says, that’s progress. We have all seen the costs of electronics equipment crash in the past few years; likewise airline prices have fallen in real terms for 30 years because of improving efficiency.
During the 2003-2007 boom, asset and commodity prices were propped up by years of loose monetary policy that had wrongly been trying to prevent faux crises. That helped create the conditions for a real credit crisis in 2008 that caused a real debt deflation that the central banks rightly intervened to prevent.
They are still intervening, though the crisis has passed, and they may be sowing the seeds for the next one.
This article first appeared on Business Spectator.