Analysis: Easy money sparks instability fears

Paul Taylor Davos, Switzerland

The world is awash in easy money, with consequences that are starting to worry central bankers and business leaders at the World Economic Forum (WEF) in Davos, though so far inflation fears seem overdone.

With developed world government finances constrained by huge debts and deficits, central banks have pumped trillions of dollars into the system to try to revive sluggish economies, combat deflation and prop up weak banks.

The US Federal Reserve, the Bank of England, the Bank of Japan and to a lesser extent the European Central Bank (ECB) have strayed far from traditional inflation fighting to take into account objectives such as cutting unemployment, raising gross domestic product and ensuring the smooth functioning of the sovereign bond market.

In pursuit of these goals, they have taken unconventional steps such as keeping interest rates well below the inflation rate, buying government bonds and mortgage-backed securities and providing long-term liquidity to banks at near zero rates.

Indeed, the Japanese central bank is actively trying to create more inflation because prices are obstinately stagnant.

Yesterday the Bank of Japan announced its most radical effort yet to end years of economic stagnation, after weeks of relentless pressure from new Prime Minister Shinzo Abe for a greater push to lift the economy out of recession.

In a joint statement with the government, the bank said it would switch to an open-ended commitment to buying assets next year and double its inflation target to 2 percent.

Central banking purists, especially in Germany, with its history scarred by hyper-inflation, worry that the guardians of sound money are losing their independence to governments and will find it hard to get the genie back into the bottle.

The leading hawk on the ECB’s governing council, Bundesbank chief Jens Weidmann, who cancelled his appearance at Davos this week, warned on Monday that governments were bullying central banks and it could lead to currency wars.

“Already alarming violations can be observed, for example in Hungary or Japan, where the new government is interfering… in the business of the central bank with pressure for a more aggressive monetary policy and threatening an end to central bank autonomy,” he said in Frankfurt. “A consequence… could moreover be an increased politicisation of exchange rates.”

Dissident Richmond Fed president Jeffrey Lacker has been warning for months that the US central bank’s stimulus actions risk causing a surge in inflation after this year.

Management consultancy Bain said in a report that the most immediate effect of a world awash with capital had been “to paralyse, confuse and distort investment decisions”.

Large financial flows were creating dangerous pockets of excess capital in some places, while cutting off access elsewhere. At the same time, big institutional investors like pension funds faced large gaps between their payout obligations and returns offered by markets.

“Capital superabundance will increase the frequency, intensity, size and longevity of asset bubbles,” Bain said, pointing to big risks for economies and businesses closely linked to commodities.

Last month the US central bank embarked on a third round of asset purchases that are meant to spur growth, and it pledged to keep interest rates near zero until the unemployment rate drops to 6.5 percent, provided that inflation expectations remain in check.

US unemployment was 7.8 percent last month, and Fed chairman Ben Bernanke made clear last week he was in no rush to tighten monetary policy, saying: “The worst thing the Fed could do would be to raise interest rates prematurely.”

A WEF survey of 1 000 business leaders and academics ahead of Davos found they continued to fear a possible “systemic financial failure”, largely due to unsustainable government finances. – Reuters