Financial markets are increasingly focussed on the diminishing effects of the ongoing
attempts by central banks to restore growth and inflation. The focus most recently has been
on the Bank of Japan (BoJ), which was one of the first major central banks to enter into
negative interest rates in January this year. Yet the impact of this policy to date has been
limited, and some may argue in fact counter-productive, given the continuing negligible
levels of growth and inflation in Japan.

However, it is not just in Japan where central bankers appear flummoxed. Despite
nearly eight years of near-zero levels of interest rates, the US economy has not seen a
meaningful acceleration in growth in the post-crisis years. Similarly, in Europe and the
UK rates of growth are far below historic norms. Investors are now questioning whether
ultra-accommodative central bank policies – emergency measures implemented after the
Financial Crisis in 2008 – are now exacerbating the problem rather than offering a remedy,
a scenario that previous Federal Reserve Chairman Ben Bernanke called the ‘’benefit, cost
and risk’. To highlight some of the challenges:

1. „„ Abundant central bank liquidity seems to have had a marginal impact on the real

   economy. Critics will argue it has pumped up capital markets to unwarranted levels,

   thereby benefiting the rich who largely hold those assets and amplifying income

   inequality even further.

2. „„ Actual inflation and inflation expectations remain low and are falling in some economies

   such as Japan. Ultra-low interest rates appear to discourage investment, leading to a

   ‘hoarding’ effect among consumers and companies. Cheap money is all well and good,

   but there has to be demand for it.

3. „„ Aggressive quantitative easing (QE) – central bank asset purchase programmes

   – diminishes future returns across asset markets and leads to a likely long term

   misallocation of capital. ‘Zombie’ companies (those that might otherwise not survive

   were it not for ultra-low interest rates) were once talked about only in Japan but there

   are worries that this may be a more general phenomenon across developed economies,

   exacerbating oversupply and general lack of pricing power.

4. „„ QE depresses longer term interest rates, presenting challenges for pension funds

   and insurers to meet future liabilities. This is a particular problem across developed

   economies grappling with ageing populations.

5. „„ Negative interest rates have a damaging impact on commercial banks’ profitability,

   hindering their ability to raise short-term deposits. These funds would otherwise be

   used to seek profit by lending at a higher long-term rate. This constraint on bank lending

   effectively represents a tightening of financial conditions.

6. „„ Currency volatility is being encouraged, but not always in a way reflecting a central

   bank’s specific objectives. This has most clearly been seen in Japan where negative

   interest rates have not had their desired effect. The yen has strengthened 15% on a

   trade-weighted basis since January and this has hurt large-cap exporters, contributing

   to weaker economic activity. In the eurozone too, the currency has been relatively stable

   on a trade-weighted basis, and now European Central Bank policymakers are more

   focussed on generating credit growth rather than boosting external demand.

7. Liquidity is likely becoming a bigger risk in bond markets. Bond prices have seen more

   price volatility over the past couple of years, albeit in isolated episodes. This has been

   particularly evident in Japan in the past few weeks, where longer-dated Japanese

   government bond (JGB) yields have seen sharp price swings relative to recent history.

   With the BoJ owning nearly 40% of the JGB market [Source: Japan Macro Advisors],

   there are worries that it is running out of bonds to buy due to the lack of sellers.

Monetary policy alone will not restore growth and inflation

Growing dissent among central bank policymakers attests to the stresses placed
upon them in their efforts to move inflation rates nearer to target. The BoJ’s ‘yield
curve control’ policy announced following the September meeting has been
positioned as a more forceful approach to lifting inflation. However, this policy,
which places a cap on 10-year JGB yields at or around zero to suppress yields at
the short-end of the curve, did not met with unanimity. Some may view it as just
another measure which prolongs and deepens the monetary policy experiment
with unknowable consequences.

Moreover, the US Federal Reserve September policy meeting saw three dissenters
who voted for an interest rate rise. The ‘hawks’ place more weight on the inflation
outlook, believing that the transitory effects of lower energy prices and a stronger
US dollar will diminish. However, others are more concerned about the strength of
the overall economy, citing the levelling off of the US unemployment rate in recent
months, due to a moderate increase in labour supply, as evidence that further
employment gains are needed before the recovery is assured.

What is becoming clear from the various September central bank policy meetings
is that central banks are struggling on their own to restore economic growth to a
sustainable trend. Hopes were high ahead of the BoJ meeting that the resulting
actions would potentially be a game changer. However, in our view, the decisions
to place monetary controls on the yield curve and implement a more flexible
approach to expand the amount of money in the economy are more evidence
that policymakers are running out of productive ideas. Their ability to impact the
real economy and to restore inflation is dwindling. Central bank commentary
continues to strike a cautious tone. The BoJ has left the door open for additional
easing. It is also significant that a data dependent Federal Reserve has revised
lower its ‘neutral’ interest rate – the level of interest rates where the economy is at
trend rate.

Ultimately, though, the burden has to fall to governments to administer policies and
foster meaningful structural economic change. This will entail piling more debt on
already highly indebted government balance sheets. Critics will say that history
shows debt on debt rarely works and that governments have a very poor track
record of allocating resources efficiently. However, even they would accept that
direct government spending has a better chance of ending up in the real economy
than current monetary tools. While the baton needs to be passed to governments,
this seems only a long-term prospect.

How should investors position their portfolios?

 

In the meantime, investors are caught between an environment littered with macro
uncertainties and one in which asset prices continue to benefit from the slosh of
central-bank-induced liquidity. We believe the most prudent strategy is to stay
close to neutral in equities, have a bias towards shorter-dated bonds, and to look
to other asset classes for alternative sources of returns. At the same time, we are
holding ample liquidity to take advantage of further periods of volatility as they
inevitably occur.

David Absolon
Investment Director

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