The ECB Proves that Central Banks Have Lost the Plot

Last month, we praised the European Central Bank (ECB) for not folding in the face of market pressure. Having promised to increase its bond buying program (QE), the bank went back on its word.

At the time, it looked as if sanity was prevailing. Here was a central bank finally telling investors they weren’t getting their way for once. Well, whatever moral victory it won that day hasn’t lasted.

Overnight, Mario Draghi, the ECB President, announced the possibility of a fresh round of QE that could come as early as March.

In a misplaced show of good faith, Draghi said the ECB wouldn’t surrender to ‘global factors’. The global factors he’s referring to, by the way, are China’s economic slowdown and weak oil prices. Markets have pinned the blame on China and oil as the reason stocks are down 10% this year.

So you can imagine the kind of boost investors felt on the back of the ECB’s announcement. Draghi hit all the right spots. He talked of a willingness and determination to prevent markets sliding further. The end goal, he says, was nothing less than inflation of below 2%. It was a real show of force from Draghi, and markets love nothing more than that.

Germany’s DAX was up almost 2% yesterday. The S&P500 closed in on gains of 1%. In early Friday trade the ASX was up half a percent. Meagre as these gains might be, they’re an improvement over the huge losses these past few weeks.

Oil prices rebounded too following a horror start to the year. The Aussie dollar even clawed back above US$0.70. In all, it was the kind of boost that markets sorely needed. Markets want the promise of more stimulus and, and the ECB is duly delivering.

With the ECB committed to more easing this year, who else is in line? What likelihood of similar bond buying programs in the US, Japan, or even Australia? For those with interest rates at near zero already, like the US and Japan, QE is very likely. But for Australia, the RBA would likely lower rates first before considering a bond buying program.

More to the point, we should be asking whether QE is sensible and necessary?

Ray Dalio, a billionaire investor and founder of hedge fund Bridgwater, thinks it is. Dalio believes more QE would help in propping up stock markets. But are stronger stock markets what the global economy needs?

Dalio believes stock market volatility creates a negative wealth effect. As share prices fall, consumers are more likely to cut back on spending…allegedly. In turn, Dalio says that weakens consumer activity, which hurts the real economy.

In truth, it’s a stretch to suggest there’s a causal link between falling stock prices and consumer spending. Where’s the evidence that share prices drive consumer spending habits? There isn’t much, if any. Yet a decline in stock prices could suggest there are problems with the real economy.

This isn’t just another way of repeating what Dalio is saying. There’s an important difference. If company earnings fall, it can lead to a decline in activity across the economy. If businesses aren’t earning as much as they’d like, they’re not spending as much either. That results in a loss of potential jobs, among other things.

So it’s the economy itself, not stock markets, which weaken spending across the economy. Stock prices are merely a reflection of what’s happening in the real economy. They don’t influence what happens in it.

Now, there’s an argument that says stock markets do have a psychological effect on consumers. Even Dalio says that more QE would be a psychological boost more than anything.

But, again, new credit has to benefit all consumers to boost the real economy. Otherwise what’s the point of QE? If it just goes towards propping up asset bubbles, does it actually improve company earnings? Not really. If anything, all it does is promote reckless business policy.

Companies are even more likely to borrow money to lavish on investors in the form of dividends. As for banks, they store it on their balance sheets. Does any of that help increase spending? No. It helps boost investor earnings, but not much else beyond that.

We shouldn’t confuse stock market psychology with economic activity. The stock market reflects the economy, it doesn’t drive it. If you need evidence, just ask yourself whether monetary easing has helped the global economy since 2008? It hasn’t, because easy credit doesn’t improve the underlying strength of economies. All it does is inflate asset prices. And if that’s the ECB is using QE for, God help us.

Will the US Fed follow the ECB in introducing more QE?

More than anything, markets want the Fed to return to old habits. They want an end to rising interest rates (which haven’t really gotten off the ground anyway). US rates have gone up by 0.25%, but apparently that’s as far as things should go.

Instead of higher rates, markets want a more flexible approach to US monetary policy. Which simply means they want more access to cheaper credit. As you’ve seen, this benefits asset prices for the most part. The effects on real economies are less obvious.

But, unlike any other central bank, the Fed’s actions matter more than most. That’s especially true in light of the complex relationship the US and China share. Fresh QE by the Fed would boost liquidity across the global economy. Liquidity levels have declined since China went from buying US dollars to selling them. As the Australian Financial Review reports:

The QE programs adopted by the US central bank in the wage of the financial crisis created a problem for China. The influx of US dollars into China in the search for higher returns threatened to push the yuan higher, which would make the country’s exports less competitive in global markets.

As a result, China used freshly minted yuan to buy US dollars to stop its currency from rising. It then recycles these US dollars into foreign assets, particularly US bonds.

Rather than facing huge capital inflows and a rising yuan, China is now struggling with hefty capital outflows (net capital outflows amounted to almost US$700 billion last year) and these are putting downward pressure on the currency. As a result Beijing is now selling its foreign currency reserves in an effort to stop the yuan from falling sharply. And this is causing global liquidity to tighten.’

Should the Fed unleash more QE, it would ease some of the pressure on China. With China the major cause of market panic, it might help calm investor fears. But it would do little to address the underlying concerns about the China. Its economy is still on course for weaker growth over the coming years. Just today, George Soros said that China isn’t capable of avoiding a hard landing. QE would merely postpone that inevitability a little longer.

Instead of QE, central banks need to tighten credit and fix the mess they’ve created. Yes, there would be pain and discomfort for everyone, not just investors. But the longer banks put this off, the worse that pain will become.

What’s more, the power that markets wield over central banks needs to end. While it’s hard to beat the central banks in the stupidity stakes, markets give them a run for their money. They’re just as responsible for this mess as the central banks are. You would never tell a smoker to quit by smoking more. Yet that’s exactly what markets are telling central banks.

This next quick fix response wilfully ignores the damage it’s doing in the long run. The growing imbalance between financial markets and real economies is a concern. And more QE will only worsen the problem, not fix it. Even India’s central bank governor sees the writing on the wall:

By intervening directly in asset prices, we have distorted some of them to the extent that the markets are not sure of what pricing is, as well as markets are not sure what the central bank reaction function will be.

My sense is that at some point the market has to live on its own. If you keep rates at such a level, you better hope that at the end of it those asset prices in fact materialise. If they don’t there is a reckoning to come. The worry is that if we continue down this path long enough, the reckoning will be pretty significant.

The ECB, and every other central bank, RBA included, should take note.

Like a boomerang, the economy has a way of coming around full circle. When a system can’t sustain new credit (debt) expansion anymore, it folds in on itself.

Ultimately, investors need to get a grip and take stock of what’s happening in the world. We need less QE, and more sanity. Even if the alternative to QE is a hard landing, it’s something we have to have. It’ll have sooner or later, but the longer this monetary easing ruse is allowed to continue, the worse the inevitable crash will become.

Mat Spasic,

Junior Analyst, Markets and Money

PS: Central bankers’ monetary manipulations are nothing new. It’s why half the developed world seems to have interest rates at near zero. And Australia is well on its way to joining the club.

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Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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