The Bank of England’s decision to borrow Mario Draghi’s bazooka has had immediate consequences: investors rushed into bonds like they’re the best investment out there. And what else could they have done? Ever since the financial crisis, central banks have dictated where investors should put their money, picking winners and losers in the markets with their asset purchases.
Some critics argue that in fact the entire financial crisis of 2007-2009 was caused in part by a mistake in Federal Reserve monetary policy. John Taylor, the author of the Taylor rule that in essence says that a central bank’s interest rate should increase by more than one percentage point for each one percent rise in inflation, is one of those critics (thanks to Oxford Economics for providing a link to Taylor’s article in a very interesting research note).
Taylor argues that during the 1980s and 1990s, monetary policy was more focused and rule-based, resulting in the Great Moderation period, otherwise known as the NICE (non-inflationary, consistently expansionary) period — a term coined by former Bank of England governor Mervyn King.
But when the Fed decided to keep the interest rate very low between 2003 and 2005, it broke the NICE rule — and that doomed us.
In Taylor’s words: “You do not need policy rules to see the change: With the inflation rate around 2%, the federal funds rate was only 1% in 2003, compared with 5.5% in 1997 when the inflation rate was also about 2%.
The results were not good. In my view this policy change brought on a search for yield, excesses in the housing market, and, along with a regulatory process which broke rules for safety and soundness, was a key factor in the financial crisis and the Great Recession.”
The latest response to various monetary policy moves around the world is an uneasy reminder of Taylor’s analysis. Capital flows data analysed by Bank of America Merril Lynch show big inflows into investment-grade bonds following easing by the Bank of Japan and the Reserve Bank of Australia and in expectation of the Bank of England’s easing measures.
In the week that ended on August 3, investment grade bond funds saw $9.2 billion inflows, the largest amount since October 2014. Equities funds saw outflows of $4.6 billion in the same week; but in a sign that investors are still hungry for yield, emerging market equity funds saw another $1.4 billion going in. It was emerging markets equities’ fifth straight week of inflows, the longest streak since September 2014.
Bank of England governor Mark Carney said last Thursday that the purpose of the re-start of the bank’s quantitative easing programme and of the additional purchases of corporate bonds is to push banks to take more risk. I don’t know if he read Taylor’s paper quoted above – perhaps he should. But then again, perhaps he’s trapped.