Growth or stability? Central banks face dilemma

It must be a strange experience, being a central banker these days. Ever since the financial crisis of more than a decade ago, central banks have had to reconcile two opposing goals — both of them self-imposed.

Whenever such incompatibilities have been in play, sooner or later the economy suffered. This time may be no different.

The first goal of central bankers is, paradoxically, that of pushing up inflation. After decades of trying to keep inflation under control, since the crisis they have been in the situation of doing the opposite thing.

The crisis and the policies implemented to alleviate its effect have left deep scars on economies everywhere. Millions of jobs were lost during the recession. A lot of people became poorer, and have therefore been buying less or watching out for bargains.

On the other hand, globalisation has been pushing companies to move manufacturing to cheaper and cheaper countries, helping to keep a lid on inflation.

You would think that low inflation is a good thing, in particular since the memory of hyperinflation with all its ills is still fresh in some people’s minds. However, central bankers are determined to push consumer prices up.

Rising prices help by reducing the value of money in real terms, therefore making it easier for borrowers to repay their debt. And boosting debt has been the central banks’ main response to the crisis, so it is understandable that they now want to put the genie back in the bottle.

The ECB could change its inflation target

Rumours that the European Central Bank will change its inflation target to make it easier to continue its lax monetary policies have been circulating for a while. More than five years ago, ECB president Mario Draghi made it clear that his focus had shifted to growth from inflation.

Last week, Bloomberg published a story quoting “officials familiar with the matter” as saying that the ECB was analysing ways in which it could adopt a “symmetrical” approach to its inflation target, meaning flexibility to go either above or below 2%.

Currently the ECB’s inflation target is “below, but close to” 2%. Although this would look as a simple change in wording, it is more than that. A “symmetrical” approach would give the central bank permission to keep interest rates low and print money even when inflation is rising.

But this first goal of pushing up inflation contradicts the second self-imposed goal: maintaining financial stability.

During the crisis, central bankers have criticised severely commercial banks’ risky loans, which ultimately led to them being bailed out by taxpayers in the US, UK and the eurozone.

But that history could repeat itself, and this time things could be even worse.

The ECB, the Swiss National Bank and the Bank of Japan are the biggest central banks that use negative interest rates. The Bank of England’s interest rate, although positive in nominal terms, is negative in real terms.

This has had the effect not only of inflating a balloon of new debt, but also  pushing investors into riskier and riskier areas in search for yield. The pile of bonds with negative yield is now worth more than $13 trillion, and there are more than a dozen European corporate bonds rated below investment grade with negative yields. Investors are literally paying for junk.

Eurozone Loan Rates

Interest rates have been falling rapidly for borrowers in the eurozone.

In these conditions, how do investors eke out a meagre return? Of course, by buying riskier and riskier assets. Take for instance Banca Monte dei Paschi di Siena, which a little more than two years ago was threatening to bring down the European banking system (again).

The world’s oldest bank was bailed out, and it now seems to be doing much better. So good, in fact, that an issue of bonds last week was more than two times oversubscribed – for a coupon of 10.5%, a rare gem these days.

But is the bank out of the woods, following its bailout? Nobody seems to care, as long as the yield is there.

These conflicting policies cannot go on forever. Central bankers have been lucky since the crisis that inflation has indeed been extraordinarily tame.

But what if a shock happens, like the oil prices shock in the 1970s? Central bankers will probably have to lift interest rates. The consequences for the pile of debt they have helped investors accumulate will be devastating.

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