Will rising inflation spoil the market’s party?

Posted: May 22, 2013 in Banking, Inflation, Interest Rates
Tags: , , , , , , ,

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Be under no doubt, record low interest rates and quantitative easing are the main reasons why equities are riding high at the moment. There is this view that central banks control interest rates; that they can determine flows of money. So why panic about rising rates spoiling the party? Central banks will only do this once the economy is back on its feet. It is just that there are reasons to think this analysis is wrong.

It is remarkable how, in this post financial crisis era, central banks still seem to operate under a kind of halo. The media and organisations such as the IMF still suggest that these central bankers are like mini gods, moving the pieces of the economy around. They are like Zeus in one of those old Hollywood movies, in which the gods of Olympus (played by the likes of Lawrence Olivier), controlled the movements of mortal man in much the same way a croupier moves chips across a roulette board.

Maybe the truth is that central banks have about as much power as Zeus does in the real world, which is to say that the sense of the central bank’s omnipotence is based on a myth.

So did central banks create the financial crisis of 2008 by letting interest rates fall too low, or were their actions largely irrelevant? Maybe the real reason why inflation fell during the 1990s and noughties was that the Internet helped to promote price competition and globalisation – in particular the rise of China – meant cheaper manufactured goods.

At the same times, ageing in Japan, China’s policy of protecting the yuan, and rising corporate profits led to a global savings glut, meaning there was lots of money sloshing around the system, pushing down interest rates. Alan Greenspan himself alluded to it when he was chairman of the Fed and he talked about long-term interest rates set by the markets being lower than short-term rates set by central banks.

But supposing things went into reverse. The Ernst and Young ITEM Club recently forecast that inflation will rise later this decade as wages increase in China, which will lead to rises in the price of manufactured goods. It also forecast that UK bank rates will be increased to 1 per cent in 2015 and to 2 per cent in 2016. On the back of rising interest rates, it forecast that mortgage interest payments will jump 15 per cent in 2015 and by a massive 23.4 per cent in 2016.

But is it possible that it is underestimating the changes that may occur?

Zeus is a myth. We now know that bankers’ hubris gets punished, and maybe central bankers have an Achilles heel. And that heel is that actually, there are forces at work – underlying forces – that are far more important than what members of monetary policy committees say and do.

Alan Greenspan once said it is the job of central bankers to take away the punch bowl as the party gets started. Maybe changes across the global economy will do this anyway, no matter how much gin and vodka central bankers pour into the QE punchbowl.

© Investment & Business News 2013

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