COLUMN-Central banks and all tomorrow's parties: James Saft

Tue Jul 1, 2014 8:00am EDT

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

July 1 (Reuters) - In focusing on their traditional role as guardians of the punchbowl, central banks are failing to see how tonight's party always slides into tomorrow's need for a hangover cure.

In a barbed annual report, the Bank for International Settlements, the so-called central banks' central bank, attacks policymakers for a misguided emphasis on the short-term ups and downs in the economy and a blindness to the longer-term costs.

The critical distinction here is between the business cycle, a six-to-eight-year cycle of ups and downs which central banks seek to manage, and the financial cycle, which is most easily viewed in terms of asset prices and which can last upwards of 20 years.

"Asymmetrical policies over successive business and financial cycles can impart a serious bias over time and run the risk of entrenching instability in the economy," the BIS report said.

"Policy does not lean against the booms but eases aggressively and persistently during busts. This induces a downward bias in interest rates and an upward bias in debt levels, which in turn makes it hard to raise rates without damaging the economy - a debt trap." (here)

Like managing a fractious child with sugary drinks at the dinner table, central banks gain some measure of control over the business cycle, though arguably this is diminishing, but are dismayed to find themselves with longer-term problems at least partly of their own creation.

The best evidence that this is true comes from asset prices, which are high and out of whack with economic fundamentals against a backdrop of growing global indebtedness since the financial crisis.

This argues that the crisis did not end the financial cycle, but instead forced central banks to put in place policies to extend it.

None of which is to say that the conditions which are causing central banks to keep rates very low aren't real and grave. Inflation is low and looks unable to consistently meet targets, job growth is patchy and biased towards lower wage areas, and wage growth for those in work is disappointingly poor.

All of which makes the current set of policy errors more understandable, but none of which makes the trap of growing debt and weak growth easier to escape.

OF POLICY AND PEOPLE

Central banks argue they can manage these risks with the help of something called macroprudential policy, essentially oversight and regulation intended to keep the banks and financial system from overheating.

The Bank of England's recent foray into the mortgage market, in which it introduced new guidelines intended to cap the number of very highly indebted house buyers, is one such example.

The BOE recognizes, rightly, that surging house prices attract more capital, whose owners seek to increase their returns by borrowing as much as possible to maximize gains.

The problem with macroprudential policy generally, and the British mortgage market changes in specific, is that, while they may stop some bad loans from being made, they do little to change the psychology of a rising asset market. You can argue that by intervening, a central bank will give the illusion that they are managing the market, making it less risky and an even better bet.

Also at issue, and a source of some risk, is how central banks can credibly communicate their intention to withdraw support and raise rates.

As we saw last year, central banks can become boxed in by their attempt to clearly communicate what policy is coming down the road. The Federal Reserve's attempt to lay the groundwork for tapering proved disruptive to financial markets, especially some emerging markets. That experience may well leave the Fed, and other central banks, unwilling to speak frankly about upcoming rate rises for fear of upsetting the very conditions of reasonable growth which make them possible.

In other words, the reaction function, the fact that markets are made up of people who anticipate, react to and attempt to game incoming information, makes forward guidance all the more difficult.

Thankfully, the potential cures for the punchbowl trap all work better once it is taken away.

While tighter credit conditions may do some damage to the economy and cause defaults, those very defaults help to better channel capital and credit to where it will generate better levels of longer-term growth.

While the BIS' critique is on target, investors should be very cautious about expecting it to be heeded.

The past 25 years are not encouraging for those hoping central banks will trade a bust of a party tonight for a better workday tomorrow. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (Editing by James Dalgleish)

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