The Global Economy Lives in Wonderland Now
by Adam Tooze – August 1, 2019
Central banks have gone fully through the looking glass, and it’s time that everyone else followed.
There was a period not so long ago when it looked as though the world’s central banks were on course to normalize. We were nearing a significant milestone on the long road back from 2008, when, in response to the implosion of the global financial system, central banks around the world had adopted a suite of unconventional policy measures. They had dropped interest rates to zero. Under the sign of quantitative easing, they purchased mountains of bonds.
Janet Yellen, then-chair of the U.S. Federal Reserve, ended its quantitative easing program in October 2014. By that point, America’s central bank had piled up $4.5 trillion in assets. Since then, the balance sheet has been run down, and interest rates have nudged up. The European Central Bank (ECB) didn’t get into the quantitative easing game until March 2015, but it ended its purchases in December 2018. Meanwhile, the Bank of Japan never eased up. But it was the exception that proved the rule.
The consensus nine months ago was that, with the world economy picking up steam, it was time to tighten monetary policy. That would allow financial markets to recover something like their normal balance. And it would give central bankers some room for maneuver in the event of an eventual downturn.
That was then. Now the question is whether the Bank of Japan may actually be the new normal. With global manufacturing slowing sharply and investors surging into the safe haven of government bonds, financial markets are flashing warning signals. The Fed’s decision on Wednesday to cut rates by a quarter percentage point and end the drawdown of its bond holdings two months early is an indication of the altered mood.
Fed Chairman Jerome Powell in the subsequent press conference did his best to deflate expectations of a sustained series of interest rate cuts. But there was no denying the significance of the moment. This was the Fed’s first rate cut since 2008. And the markets wanted more. The spread between short and narrow bond yields tightened, signaling that the markets are now more concerned than ever about a recession, and equities closed down. That was enough to trigger angry tweets from President Donald Trump about the Fed failing to keep pace with either China or Europe.
Trump is right about one thing. The Fed is not alone in taking action. The People’s Bank of China has made clear that it will provide as much stimulus as it can without endangering the threshold exchange rate of 7 yuan to the dollar. The last thing the world economy needs right now is for currency movements to provoke further belligerence from Trump.
While the Fed is cautiously cutting rates, the ECB is discussing more radical options. It is already charging European banks negative interest to hold their deposits. If it cuts deeper into negative territory, it is sure to spark protests from banks and savers. As an alternative, the ECB may have to consider restarting quantitative easing, which will require it to find ways around its own self-imposed rules that cap the percentage of a member state sovereign debt it may purchase. The ECB is haunted by the fear that if it goes further, it could find itself accused of printing money to finance borrowing by member states. The question of ECB bond buying is being litigated in front of the German supreme court this week.
Alternatively, the ECB might follow the Bank of Japan and buy equities rather than sovereign bonds. The Bank of Japan already owns 4.7 percent of the Japanese stock market. This is the path that no lesser authority than BlackRock is urging the ECB to go down. Apparently, the world’s largest asset manager sees nothing wrong in arguing the case for open-ended official support for one of the world’s most undervalued equity markets.
What has happened to change the outlook so drastically? How have we ended up sliding back in the financial twilight zone? And what are the implications for the future?
The darkening mood has both immediate and deeper causes.