Exuberant markets and fragile economies pose policy puzzle

LONDON, July 14 Mon Jul 14, 2014 11:03am EDT

LONDON, July 14 (Reuters) - A ripple of financial contagion from a troubled Portuguese bank and a warning that markets have got way ahead of the sluggish economies that underpin them have fired up new debate about an appropriate policy response.

The Bank for International Settlements said two weeks ago that ultra-low interest rates had lulled governments and financial markets into a false sense of security.

"Overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally," the global central bankers' club said.

That warning gained potency when troubles at Portugal's largest listed bank prompted a worldwide market sell-off last week.

After a prolonged period of bonds and stocks both heading higher, did this herald a return of the contagion seen from the fall of Lehman Brothers to the euro zone debt crisis?

There are good reasons to think not, given Portugal's ample resources to recapitalise Banco Espirito Santo - which may not even be needed - and the relatively contained nature of the family-controlled owner's troubles.

But the broader issue of a potential disconnect between market exuberance and economic reality remains. Stocks at record highs and house prices rocketing in countries like Britain have been offered up as signs of new asset bubbles.

Minutes of the Federal Reserve's last meeting showed some concern among its policymakers.

"Low implied volatility in equity, currency, and fixed-income markets as well as signs of increased risk-taking were viewed by some participants as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy," the minutes said.

The conclusion appeared to be that there wasn't much the Fed could or should do about it. The BIS argument is that there is, and the answer is higher interest rates.

Tim Duy, economics professor at the University of Oregon and a noted Fed watcher, said the U.S. central bank could indeed create more uncertainty by sounding more hawkish.

"The Fed, however, is not yet sufficiently concerned about complacency to attempt to gain more financial stability at the cost of economic growth," he said.

The counter-argument is that markets are responding entirely rationally to a wall of new money created by the Fed, Bank of Japan and Bank of England in an attempt to pull their countries out of crisis, much of which has flowed into shares and bonds.

Bank of America Merrill Lynch said the Fed was erring on the side of tightening too late rather than too early, the European Central Bank would need to see a more imminent threat of deflation to agree on printing money and others were at pains to douse any talk of tighter policy.

"The result is historically low rates and FX volatility and broken correlations with data and fundamentals," the bank's economists said in a note.

SCATHING

Some such as Larry Summers, a former U.S. Treasury secretary, argue that the world is now in a period of "secular stagnation" that requires even lower interest rates. The trouble is that they are already at or near zero so cannot fall further, condemning major economies to lacklustre growth at best.

If rates are to stay ultra-low the pricing of financial markets looks less exuberant. But if inflation returns, and central banks have to respond, all bets are off.

Nobel laureate Paul Krugman said the BIS argument boiled down to targeting a level of interest rate to discourage asset bubbles, the end result of which would be economies "kept permanently depressed in order to curb the irrational exuberance of investors".

Simon Wren-Lewis, economics professor at Oxford University, was more scathing.

"Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again," he wrote on his blog.

"I do not know what planet these people are on, but if it's mine, can they please get off and play their games elsewhere."

Wren-Lewis noted the case of Sweden which raised interest rates in 2010 because of worries about household debt and housing bubbles even though inflation was no threat.

Now inflation has evaporated and earlier this month the Riksbank cut its key rate back down to 0.25 percent in an attempt to push up price pressures and generate some growth.

There is little sign of central banks following the BIS advice. Senior policymakers from Fed chief Janet Yellen down have highlighted "macroprudential policies" - such as toughening rules on the size of house loans to curb property price bubbles - as the appropriate response.

But many economists say such measures will only work in tandem with monetary policy not as a substitute and either way the BIS has put its finger on a potential threat - markets that have travelled an awful long way without really correcting.

The Dow Jones industrial average recently broke above 17,000 for the first time having dropped below 6,500 at the height of the world financial crisis in 2009. Spanish 10-year bond yields have fallen from around 7.8 percent in late 2012 to 2.8 percent now.

The Fed's mere mention of slowing the pace of its money creation programme last year put emerging markets into a damaging spin.

Now, it will have ended its bond-buying by October, the Bank of England could raise interest rates not long after and the ECB seems reluctant to turn the taps on. So the largesse that has propelled markets is slowly dwindling with critical stress tests of European banks also due late in the year.

"It's not Espírito Santo that's the problem, it's the bleak fundamentals of the euro zone periphery which have become worryingly detached from the region's buoyant financial markets," said Nicholas Spiro, head of Spiro Sovereign Strategy in London.

"The tug-of-war between central bank largesse and economic, financial and political vulnerabilities in the euro zone has been dominated by the latter ... The question is whether Espírito Santo jolts investors out of their complacency about the risks in the euro zone." (Editing by Jeremy Gaunt)