Uncertainty is still the only certainty

Sometimes you come across data that seems to capture the current mood.  This was the case with a survey by an investment firm showing that 32% of wealthy investors plan to increase their holdings of cash over the next 12 months.  This change in asset allocation toward cash is strange considering some investments such as stocks are having a stellar year while returns from leaving money in the bank have been dismal.  This high level of caution shown by investors, who typically have advisers telling them where to put their money, highlights the level of uncertainty faced by those trying to invest their money.  Yet with a number of possible hiccups on the horizon, cash seems to be the least bad of a poor range of options. 

The key concern for many investors is the upcoming reduction (so-called tapering) of bond purchases by the Federal Reserve.  Improvements in the US job market are expected to see the Federal Reserve cut back its monthly purchases of US$85 billion worth of bonds in the next few months.  One of the side-effects of this monetary policy has been to push investors away from bonds and into riskier assets such as stocks which has helped to lift the S&P 500 up 26% so far this year to record highs.  The actions of the Federal Reserve have grown to be the dominant factor in the direction of share prices with investors placing more stock in announcements from the central bank than data on the strength of the underlying economy. 

There has been a debate raging over the extent of the influence of the Federal Reserve with some degree of distortion inevitable considering the scale of the bond buying operations.  Share prices could be overinflated and a sharp fall might be necessary to find their correct value.  Alternatively, any changes from the bond buying end may be minimal and it may just be worries about what might happen that is scaring off investors.  Some experts argue that it is good news that investors are holding a lot of cash as it suggests that shares are not yet overpriced and this cash may still flow into the stock market over the next year.  However, in this scenario, the smart money would already be invested in stocks. 

The uncertainty is such that investors are shunning higher returns from stocks for much lower pay-outs from leaving money in their bank (the best efforts of Your Neighbourhood Economist resulted in yours truly being locked into cash for two years to eke out a miserly interest rate of 2.0% through a UK savings account).  Among the few certainties for investments over the next year or so is that a considerable amount of volatility is likely as investors try to figure out what the Federal Reserve will do next and how other investors will react.  Great if you like investing to be like a roller coaster ride, but the rest of us may be better off settling for meagre returns from our banks.  

UK economy is growing but not yet in recovery

Some good news at last for the UK economy but don’t expect the tough times to be over

The outlook for the UK economy is finally beginning to brighten following a harsh recession and weak recovery.  The Office for Budget Responsibility raised its forecasts for the UK economy with growth of 1.4% expected in 2013 up from a previous estimate of 0.6% in March while 2014 is expected to see growth of 2.4% instead of a prior March forecast of 1.8%.  While the government was keen to publicise this as good news, much of the improvement is due to factors that are likely to be temporary.  Government measures along with monetary policy are behind the perkier economy but the effects will not last and a proper recovery may still be some time away.

The unexpected boost to the economy has come through higher spending by households.  Many UK consumers are feeling better off with UK shares near record highs and the UK property market going through a period of resurgence.  Stock markets in many developed countries have been providing stellar returns as extra cash being printed by central banks flows into shares.  House prices have benefited through a range of government schemes aimed at increasing the availability of mortgages.  This has translated into more consumer spending through a mechanism known as the wealth effect which is the notion that people will spend more if the financial assets which they own are worth more.  The UK government has tried to tap into this effect on spending using schemes such as Help to Buy to lift house prices as a means to boost the economy due to few other options (such as higher government spending) being available. 

The wealth effect relies on growing levels of financial wealth which can be lifted by different measures but which ultimately rely on the health of the economy.  As such, temporary boosts are possible but asset prices (and wealth) can only be pushed up so far and may involve potential negative effects for the economy.  Higher prices for financial assets now come at the cost of price gains in the future  (such as a weaker property market in the future) with a reduced wealth effect.  This may be a necessary price to pay with few other avenues for generating growth but the tactic of pushing up property prices has also been used by the UK government to provide cover for its program of austerity measures. 

With public debt reaching around 75% of GDP in 2012, the government has given priority to cutting back its spending but this is controversial coming at a time when the overall economy is weak.  The government claims that the cuts are necessary as investors would not buy UK government bonds (resulting in the government having to pay higher interest rates) were government debt to get even more out of hand.  Concerns about debt levels have eased considerably since reaching near frantic proportions during the Eurozone crisis, but the government remains unrepentantly committed to slashing spending levels.  Cuts to government spending are going to continue for years to come with the stated goal of reaching a budget surplus by 2018 despite calls for a change in policy.

Other areas of the UK economy also have little to offer in terms of growth.  Exports from the UK have failed to pick up despite a weaker pound and the value of the currency has begun to rise again which does not bode well for UK exporters.  Investment is also weak with lending to businesses in decline.  It is proving tough to come up with an engine to drive growth in the UK – a recovery is long overdue but we may still have to wait.

British banks gone AWOL

The banking sector is in dereliction of its traditional duties in the economy and quick fixes will not be enough to make amends

After nearly collapsing and bringing the economy down with them, UK banks are further adding to their bad name by holding back the economic recovery.  Banks are either too weak or too caught up in making easy money to fulfil their traditional role in the economy.  The situation is made worse because monetary policy works through the financial sector and banks are crucial links through which money is fed into the actual economy.  Instead, bank lending to UK businesses has been falling, thereby dampening the impact of lower interest rates and pushing the Bank of England to pump more and more money into the economy (which is not healthy).  Why have banks seemingly abandoned their posts?

Banks have traditionally acted as intermediaries between those with money to spare and those in need of financing.  There is a surplus of funds at the moment due to quantitative easing by the central banks which is aimed at getting more households and companies to borrow.  But this money is not getting to businesses - partly because the weak economy has hit demand for loans but also because of the reluctance of banks to lend.  A large amount of debt, which could go bad due to the weak economy, is making banks cautious while new banking regulations are restricting banks’ capacity to take on fresh loans.  Small businesses have been hit hardest as there are few other options for getting cash.  As a result, there has been a large knock-on effect on the economy as small businesses are a significant source of jobs and innovation.

Other parts of the finance sector have failed to pick up the slack.  Investment banks (which are different to retail banks who carry out the functions above) have long had only weak links with the actual economy and continue to generate profits through their ability to make money from money while also attracting some of the best and brightest who could offer more in other sectors (see previous blog).  Firms such as Wonga, which offer lending services now shunned by retail banks, are being hounded for their trouble.  The only bright spot has been mortgage lending but that has been targeted by government initiatives along with monetary policy to the extent that the Bank of England has had to apply the brakes due to concerns about a housing bubble.

The failure of banking to facilitate the circulation of funds around the economy has resulted in surplus cash flowing into financial assets such as property or the stock market rather than being put to productive use in the actual economy.  The Bank of England has tried a scheme of providing banks with funds for lending but more needs to be done to clean up banks and change their behaviour.  One of the reasons why Japan took so long to recover from a financial crisis more than two decades ago was that it allowed problems in its banking sector to stagnate.  Let’s hope that it doesn’t take that long to learn the same lesson.

UK Property Market – Prudence over Politics

Why we should be happy that the Bank of England is putting the brakes on the government’s efforts to boost the property market.

It is the job of politicians to get elected, but it does not follow that governments always do what is in the best interest of voters.  This might be the best explanation behind the actions of the current UK government with regard to the housing market – angling for voters (and an economic recovery) by pumping up property prices with little concern about the long term health of the economy (for more on this, see rebound in UK house prices is not all good news).  Many expressed a sigh of relief when the Bank of England stepped in to put the brakes on a booming real estate market by taking away incentives promoting mortgage lending among banks.  It is something new to see a central bank taking a stance which puts them at odds with the government but it provides a good case for arguing for greater oversight of government policy.

The current understanding of the role of a central bank is as an independent body which watches over the economy with powers to intervene if there is too much or not enough growth.  Central banks are kept separate from politics where policies are aimed at winning over voters within a time frame of a few years.  Some aspects of government where a longer time frame is required such as monetary policy could be influenced in a negative way by political calculations and it is thought that central banks are better positioned to administer monetary policy in order to achieve goals such as warding off inflation.

The global financial crisis highlighted that low inflation in itself is not sufficient for financial stability with aggressive lending by banks combined with excessive gains in asset prices also shown as big threats.  Central banks have been given greater scope to oversee the overall health of the financial sector and this is behind the latest policy actions by the Bank of England.  The UK government was hoping that a buoyant property market would increase spending and create a feel-good factor propelling it back into power in elections scheduled for 2015.  Yet any gains in real estate prices without higher wages would be unsustainable and put home ownership beyond the reach of many, ultimately requiring weaker prices in the future to bring house prices back in line with the economy. 

Governments and central banks had previously been operating in their own separate spheres of influence but the extended remit of central banks may bring them into conflict.  This has the potential to work in a positive way to provide greater oversight for government policies shown to be at fault in the past (for example, high government borrowing in the UK in the run up to the global financial crisis).  Another example of how the European Central Bank did the most to save the euro while the various governments in Europe squabbled.  It is not hard to argue for giving more power to economists (see previous blog) when politicians provide so many reasons for doing so.  

Federal Reserve – preparing to taper

With crunch time coming up, the Federal Reserve puts in the groundwork for a key change in policy

In the long march of dealing with the aftermath of the global financial crisis, the recent baby steps taken by the Federal Reserve may be one of the most crucial parts of the journey.  The Federal Reserve is considering lowering the interest rate on reserves it holds for banks as part of a move to offset upcoming reductions (tapering) in its bond purchases which currently amount to US$85 billion each month.  This tapering is perhaps the most important policy change in the past 12 months with the health of the global economy in the balance, so the Federal Reserve is anxious to ensure all goes well.

The actions of the Federal Reserve have been keenly felt across the globe with stock markets everywhere buoyed by the extra cash sloshing around the international financial system.  This abnormal state of affairs where central bank policy dictates the movement of stock prices is increasingly creating distortions through excessive gains in stock prices.  A pickup in the US economy would mean that the extra stimulus is no longer needed, but a smooth transition as the Federal Reserve changes tack will be key to sustaining any economic recovery in the United States and elsewhere.

As such, the Federal Reserve has been keen to soften the blow to the stock markets with policies that act as a stimulus as it cuts back on the bond buying which has been the main focus of its expansionary policy.  The mere rumour that the Federal Reserve would buy fewer bonds resulted in the interest rates on 10-year US government bonds jumping from around 1.7% in May to almost 3.0% in September.  Forward guidance, with future hikes in interest rates linked to unemployment, was tried as a means to signal the intent to help the economy but investors did not buy it (see prior blog for more).  

Changes to interest rates on banks’ reserves which are under consideration will only probably have a minimal effect but it is the signalling by the Federal Reserve that may be more important.  By showing a willingness to continue to support the economy, the Federal Reserve eases concerns that its actions will trample over the nascent economic recovery.  Some of the best successes of monetary policy have taken effect through nothing more than the suggestion of future action, such as the promise by the European Central Bank to do “whatever it takes” to save the euro.  This convinced enough people that it put paid to the Eurozone crisis without a single bond being purchased or interest rate being changed.  

Your Neighbourhood Economist was previously critical of the Federal Reserve for not taking the opportunity to begin tapering in October but the extra couple of months have been put to good use in ensuring that the change in policy goes smoothly.  All eyes will now look to the next meeting of the Federal Reserve (17th to 18th December) when tapering may be announced especially if US job data released on the first Friday in December is seen as positive.  The Federal Reserve is taking a cautious line but it is worth ensuring that there are no stumbles in the finishing stretch.

Not so Great Expectations

Economists are sticking to old ideas about our behaviour but is it time to ask them for some more?

Economics has grown in popularity as people try to make sense of the troubles in the economy.  At the same time, what is taught as economics is being challenged after economics provided little help in predicting the global financial crisis or dealing with its aftermath.  Your Neighbourhood Economist has a particular issue with the common view among economists about how people think about changes in prices and interest rates.  This way of thinking has pushed monetary policy in the wrong direction as economists rely on theory which is increasingly being shown to be detached from reality.

The above position is based on the concept of rational expectations where people’s predictions of the future are built into economics models.  This first came to prominence during the 1970s where persistent inflation was a problem - high inflation had resulted in demands for higher wages which pushed up the costs of businesses and thereby led to businesses charging even higher prices.  The notion of expectations enabled economists to explain the reasons behind rising wages.  Since then, inflation has been tamed through new policies which make price stability the main focus of central banks under the rationale that people will not expect inflation to get out of hand if the central banks are on the case.

Central banks have been successful in handling inflation but other problems such as reigning in financial crises and dealing with the aftermaths of such have proved harder to manage.  Economists have been using the same tools through forward guidance which aims to boost lending by instilling expectations that interest rates will stay low for an extended period of time.  At the same time, measures to restore the economy have been restricted by concerns about the possibility of triggering a surge of inflation if central banks are seen to be less vigilant.  Surveys of people’s perceptions of inflation are now commonplace and followed by inflation-fearing economists almost as anxiously as politicians track polls on their popularity.

Yet times have changed.  Inflation is no longer such a big deal - globalization has resulted in increased competition which keeps down prices and weaker labour unions are unable to impose the industry-wide wages hikes of the past.  The average person on the street is not overly concerned about inflation in comparison to other worries about the economy so our actions are no longer shaped much by changes to prices.  The same is true for deflation - although the faltering economy in Japan is brought out as an example of what can go wrong, it is likely that Japan is an anomaly rather than a model applicable to other countries.  The old ideas on economics have not served us well in getting the global economy up and running again suggesting that economists ought to change their thinking to help deal with the hard times. 

Good Deflation better than Bad Inflation

Central banks seem to be keen on avoiding deflation at any costs but inflation for its own sake is likely to be worse  

Inflation is on the retreat in much of the world giving rise to concerns about deflation.  Economic theory along with the experiences of Japan makes deflation one of the most feared outcomes in economics.  The central bank in Japan is planning to double its money supply as part of its battle to end deflation while the European Central Bank cut interest rates after inflation figures in October were too low for comfort.  The fears about deflation have resulted in policies which suggest that inflation in any form is better than deflation.  But deflation is a symptom of bigger problems and the prescribed cure may do more harm than good.

Economics textbooks paint a grim picture when it comes to deflation – lower prices translate to less money to pay off debts for both businesses and governments with consumers holding off on purchases if today’s prices are likely to be lower tomorrow.  Japan has been a case study of the damage done by deflation –the bursting of a gigantic financial bubble in 1989 resulted in around two decades of falling prices seen as sapping the life out of the Japanese economy while government debt has reached around 230% of GDP.  The years of deflation reinforced the notion of deflation feeding upon itself to reduce demand for goods and services and further drive down prices.

However, according to this rationale, deflation is the cause of the problem rather than simply a sign of a sluggish economy.  The reasons behind deflation are based on prices being too high as a result of unsustainable price increases in the past.  We can see an example of how this works in that stock prices in Japan are still less than half their peak value, highlighting the extent to which prices can be massively overinflated.  Prices for consumer goods are not subject to the same price pressures as in the stock market but the example illustrates the consequences of economic overheating.

There are parts of Europe with similar issues but nowhere is close to being on the same scale.  So, while Japan shows what can happen, its relevance to Europe is likely to be limited.  The deflation emerging in Europe, such as in Greece and Spain, is the result of weak demand coupled with falling wages which helps businesses by lower their costs.  The lower wages are needed for these countries to regain their competitiveness relative to the rest of Europe as other options, such as currency devaluation, are not available for countries in the Eurozone.

The response of central banks in Japan and Europe has been to use monetary policy to weaken their respective currencies but this targets the symptom and not the problem.  A weaker currency increases the price of imports and is tantamount to paying foreigners more to buy stuff just to create inflation for its own sake.  However, higher prices are more likely to result in consumers tightening their belts as their purchasing power diminishes.  The idea that low inflation requires more of the same approach misses the fact that these monetary policies bring their own costs with little benefit.  Deflation doesn't seem so bad in comparison.

Monetary Policy – via the currency market

With the banking system clogged up, the European Central Bank is looking for other ways to make monetary policy work

Unconventional - this is a term currently used to describe many new elements of monetary policy such as quantitative easing.  It could also be employed in relation to the manner in which monetary policy works nowadays.  The European Central Bank (ECB) cut interest rates in November 2013 due to concerns about deflation (for more info, see previous blog) but the effects are not expected to work through the banking sector as would normally be the case.  Instead, the unspoken target of the policy change was the value of the euro.  This is stuff that you won’t find in any economics textbook, so how does it work and why is the ECB having to rely on such disingenuous tactics for its policies?

The normal result of a cut in interest rates would be a boost to the economy through an increase in lending with lower borrowing costs convincing more households and businesses to take out loans.  The extra spending that this generates would spur on the economy.  But this policy route is not working at the moment as demand for new loans is weak irrespective of how low interest rates are.  The fall in inflation has prompted growing concerns about deflation and the ECB felt the need for further action to signal its intent to prevent this.

Accordingly, the ECB is targeting another avenue (without stating it outright) to achieve the desired results – the currency market.  Europe has been burdened with a currency which reached a two-year high against the US dollar in October.  This is relevant to the fight against deflation in two ways – a stronger currency hurts the economy by making exports more expensive (and harder to sell overseas) as well as reducing the prices of imports (which adds to downward pressure on prices).  A reversal of this trend, that is, a weaker currency, would then work in Europe’s favour and is one of the few levers available to the ECB.

A lower interest rate helps to drag down the value of a currency by reducing the benefits of holding cash in that currency and providing an extra incentive to sell.  This effect is further magnified by the large amount of cash sloshing around in the global financial system at present.   But it is not so easy - some other central banks (namely the Bank of Japan) are keen on achieving the same results through similar policies and not all countries can have weak currencies.  This has resulted in the coining of the term "currency wars" as countries battle to drive down the value of their currencies.  It all sounds rather dramatic but it is evidence of how things in the system of finance are far from normal.

ECB Rate Cut – what's the point?

The European Central Bank set itself apart with looser monetary policy but how is this likely to make any difference to the economy?

Central banks have been busy recently, whether it be talk of forward guidance from the Bank of England or the tapering of bond purchases by the Federal Reserve.  The exception had been the European Central Bank (ECB) which had been going through a quiet period after monetary policy helped to put paid to the Eurozone crisis in 2012.  Worries about deflation jolted the ECB back into action following data showing that inflation was down to 0.7% in October.  The ECB decided to respond last week by cutting its benchmark interest rate from 0.5% to 0.25%.  But, with interest rates already low, will a further reduction make much of a difference to the economy?

A cut to interest rates is something of an anomaly as the ECB is the only major central bank which has not already lowered interest rates as much as possible.  The recent trimming of its key interest rate follows cuts in July 2012 and May 2013 with the ECB using this drip-feeding of interest rate changes to respond to new data on the economy in Europe.  The focus of policy has shifted from saving the Eurozone from collapse, which was achieved by the ECB taking a stand pledging to do “whatever it takes” to save the euro. Instead, the ECB is looking to boost growth with the hope of staving off deflation.

Lower prices may sound like a blessing to consumers but this fall has the effect of making debt tougher to pay back as selling the same amount of goods generates less money for firms which also means that the government misses out on tax revenues.  Not exactly what a heavily indebted Europe needs at the moment.  This is the reason why central banks will typically adjust policy to achieve inflation of around 2% - better to have a small amount of inflation than succumb to deflation.  Inflation has been decreasing elsewhere as well such as in the UK (see previous blog) due to weak growth combined with a fall in global commodity prices (see Inflation – then and now for more on how inflation works).

The interest rate cut in itself will actually have little effect with households and businesses in Europe not keen on borrowing while the economy is so weak.  Rather it is a signal of intent – the ECB will continue to loosen monetary policy while some central banks elsewhere (the US and, to a lesser extent, the UK) are approaching the beginning of the end of their loose monetary policy.  The key mechanism by which this will be fed through into the economy is likely to be the exchange rate but more on this later…

The ups and downs of UK inflation

Inflation has become delinked from the UK economy but at least it seems to be heading in the right direction

Something seems off.  Inflation figures for the United Kingdom released this week show that inflation dropped to 2.2% during the 12 months up to October.  Inflation had previously been high despite the sluggish UK economy but inflation is now on the way down just as the economy is picking up again according to data released at the end of October showing the fastest rate of economic growth in more than three years.  Any links between inflation and the health of the economy take on extra meaning due to the level of prices being the primary concern of central banks.  So how is the Bank of England likely to react to such mixed data?

Inflation typically moves in line with the economy – increasing during boom times and falling when times are bad.  But as mentioned above, this relationship does not always hold as economic growth in places other than Western countries, such as China and other emerging markets, can affect prices for global commodities, a situation which was not always the case (for more on this, see Inflation – Then and Now). The strength of the Chinese economy explains how inflation in the UK could briefly exceed 5% near the end of 2011 while the economy was struggling.

Although the main goal for the Bank of England is to maintain price stability which involves keeping inflation close to around 2%, the high inflation in 2011 was not seen as a problem on the basis that the factors behind the higher inflation were judged to be temporary (and this turned out to be correct).  More persistent inflation typically comes with more sustained periods of economic growth as increased wealth pushes up demand and results in rising prices.

Accordingly, it may be a good omen that lower inflation has come at a time when the fortunes of the economy are beginning to brighten.  It will give the Bank of England more leeway to keep interest rates lower for longer.  However, it is not clear whether inflation will continue to fall – energy suppliers are planning to hike energy prices while the government will be keen to limit higher fuel bills.  Energy costs will also be dampened by China no longer experiencing the rampant economic growth of the past decade.   At least inflation will be one less thing that the Bank of England will need to worry about with the tricky prospect of interest rate rises on the horizon.

Wonga - Do we need to be saved?

Politicians are questioning our ability to make the right choices but that is not the real problem.

Criticism of Wonga recently reached a new nadir with the rather ridiculous claim by Ed Miliband, the Labour Party leader, that children have been “targeted” throughTV ads.  There does seem to be something unethical about a firm which charges almost 6,000% interest on loans.  However, this hasn’t prevented Wonga from prospering.  With wages stagnating for many people, there is strong demand for extra cash at times of need even if it does come with a big chunk of interest payment.  Yet, many in the media have been critical of a culture of borrowing with Wonga as the new pied piper (see my previous blog on Wonga).  Are Wonga’s loans useful in times of trouble or a snare for the unwary?

One of the key elements of a capitalist economy is that firms will sell any product where profits can be made.  This drive for profits pushes companies to innovate and create things that we didn’t even know we wanted.  The short-term loans from Wonga are one such product allowing quick access to cash that was not previously available.  Their popularity suggests that many find such loans useful, but it also prompts concerns that people are not making the smartest financial decisions.  Politicians among others target the source of supply (the firms offering the loans) rather than the source of the problem which is too complicated to deal with.

This paternalistic way of thinking is the basis for government action on a range of our “bad habits” from smoking (where policies have worked out for the best) to alcohol and fast food (which have been controversial).  Government policies such as these which try to modify the behaviour of adults sometimes seem like a replacement for a decent education system.  The world is growing in complexity and we are faced with an increasing range of choices at the same time as education is becoming increasingly focused on test results.  This leaves teachers with little time to teach important life skills such as a healthy diet or financial literacy.  Politicians could do us all a favour by asking the bigger questions rather than jumping on the latest bandwagon – if only there was a way to improve the behaviour of politicians.

Wonga – the new bad boy of finance?

Wonga has been grabbing headlines for the wrong reasons but who is really to blame?

It is not a good time for finance firms of any guise to be making too much money at the moment.  So the British short-term lender Wonga attracted the wrong type of attention when it announced record profits of 65 million pounds for 2012.  Everybody from Ed Miliband, the Labour Party leader, to the Archbishop of Canterbury have lined up to vilify Wonga for making money out of people who have fallen on hard times.  Wonga, who offer loans of small amounts for a period of up to 30 days, have hit back with a slick new promo video telling the stories of some of its customers.  Is Wonga as bad as they say or is the recent controversy just a bit of name calling to grab some headlines?

Among the numerous criticisms, perhaps the most commonly heard are to do with the eye-wateringly high interest rates which work out at 5,853 percent (as stated clearly on the website).  Yet the short periods of borrowing mean that interest payments are typically small compared to the amounts involved - a typical loan of 200 pounds for 15 days incurs fees and interest of just over 36 pounds.  But 200 pounds would explode out to over 10,000 pounds over 12 months so any mishaps which delay repayment have the potential to spiral out of control and result in massive debts.

So why would people risk this in the first place?  A bit of extra cash when we are short might save us even more money than the cost of the loan when caught in a spot of trouble or might stop us from missing out on a big night out with friends just before payday.  The choice to borrow or not to borrow is one that each of us is free to make (with full disclosure of charges from Wonga).  What the long line of Wonga critics are instead condemning is the fact that so many people are choosing to take out loans through firms such as Wonga.

Wonga is a symptom of and not a cause of a society that spends at will and may not always have money left at the end of the month in case of emergencies.   Life was not always so free and easy - access to any extra cash used to be limited to only those on good terms with their bank managers.  But new ways of getting cash, such as credit cards and short-term loans, have provided money to the masses.  We should be thankful to have it if we need it but better management of our finances might mean that we would be thankful not to need it.

Generational Differences - Rise of the Socialists

Young people have a different view on the world than older generations who have made the most from capitalism

Youth is the one thing that most people would want – a chance to live it all over again – but it is not an easy time to be young at the moment.  Young people are facing the toughest job market in decades after having gone through an education system which has been neglected for years with more money being spent on pensions instead.  So it may not be surprising that youngsters are not as keen on capitalism as older generations.  And this is not just part of a rebellious phase but rather a response to an economic system which is geared to benefit long-time members to the detriment of new-comers. 

To start with, let’s look at the job market.  Unemployment rates remain stubbornly high in most countries with developed economies but the proportion of young people without jobs is typically substantially higher.  For example, more than half of younger workers in Spain and Greece are unable to find work.  Joblessness not only has temporary effects such as a loss of income but studies have shown that youngsters who enter the market when the economy is sluggish often earn less over their lifetimes.  The current situation for young people goes beyond this to talk of a “lost generation” who may become disillusioned with the job market and remain disengaged even when employment prospects improve.

This situation is made worse by a system fronted by labour unions geared to protecting the jobs of existing workers who come from an older generation.  This trend has been most damaging in Europe where the efforts of unions have resulted in a two-tier labour market.  Older workers have secured themselves stable jobs due to rules resulting in high redundancy costs whereas younger workers are typically employed on short-term contracts which are first to be terminated when job cuts are needed.  The rise of globalization also means that new-comers to the workforce are competing for jobs with workers in China and India as well as people in their hometown. 

This increased competition for jobs along with automation of work using computers and other new technologies has taken away many of the administration jobs that were the mainstay of work for the older generation.  Better paying jobs are increasingly limited to jobs requiring higher levels of education but this too is an area where young people have been short-changed.  Education is faced with spending cuts and students are being asked to bear a substantial portion of the costs as countries deal with high levels of debt as well as demands from older workers for lower taxes.  The irony of this situation is that spending on pensions and medical bills for the elderly is on the rise at the same time as education is suffering from cutbacks – societies are spending money on the old rather than investing in a new generation.

The housing market provides further evidence of the different fortunes of the older and younger generations.  Trying to get onto the property ladder is only getting tougher for first-time buyers whereas existing owners of property are benefitting from higher prices.  House prices have been surging in some places despite the economic doom and gloom as governments in many countries have even been bringing in measures to push up prices for real estate as a means to revive economic growth (which is why a rebound in UK house prices is not all good news).

With lower pay in less stable jobs (or unemployment) awaiting many youngsters, they are likely to be the first generation in a long time that will end up worse off than their parents.  The older generation must take part of the blame with many elements of the economy set up for their benefit – a seemingly obvious outcome in a world defined through competition where everyone from companies to political parties are battling it out.  The spoils from winning in this competitive environment are on the wane in wealthier countries as global economic rebalancing shifts more wealth to China and other countries on the rise (which is part of A New Inconvenient Truth).

Youngsters have experienced the harsher side of a market economy and it is no surprise that they see the current system as not working in their favour.  Surveys show a growing distrust of capitalism and increasing support for social spending among young people.  The disillusionment of young people has also extended to politics so it is later generations which vote and give direction to the policies of government.  But it seems obvious that changes beckon as the younger generation with their different experiences and views on the world take over the levers of power.  Marketing experts have been quick to jump on changes in habits of different age groups such as Generation X or Y.  Politics may see similar changes coming with the rise of a new generation – it will be interesting to see what world they will build for themselves.

Debt Ceiling: Once more unto the breach

Politics in the United States is starting to cause more problems than it solves as compromise still seems far off.

Politicians are not usually seen in the best light.  Even in that context, the partial shutdown of the federal government in the United States is exasperating, so much so that Your Neighbourhood Economist was not even going to bother to comment.  The situation leading to the shutdown brings to mind kids in a playground fighting over a toy with everyone losing out after all of the toys are put away.  However, behind all the antics and posturing, there are bigger themes at play which is even more depressing.

October is marked with a number of dates which gradually ramp up the economic stakes.  The month began with the US government having failed to pass legislation for its spending budget for the 2014 fiscal year which starts on 1^st October.  While the bulk of spending by the government, such as benefits for the elderly or unemployed, is not affected, a significant portion of money doled out by the government must first be ratified by Congress before being spent.  As a result, not passing the budget resulted in a partial shutdown of the federal government with around 800,000 out of 2.8 million public employees being sent home without pay.  The parts of government affected include bodies such as the Environmental Protection Agency and the Food and Drug Administration, meaning that many procedures such as permits for certain business activities will not be processed.  NASA will also mostly shutdown as will many of the tourist sites overseen by Federal government employees.

But the partial government shutdown is just a precursor to something more threatening – the government running out of money to pay its bills.  While such an outcome may sound preposterous, it stems from the current budget deficit (with the government spending more than it receives) and the need to borrow to make up the shortfall.  The total amount of debt that the US government can take on is also something that requires approval from Congress.  With the government having racked up a string of budget deficits in the aftermath of the global financial crisis, the amount of borrowing has been steadily rising.  More debt is needed but the government has reached the debt ceiling which was raised in 2011 and is expected to run out of money by around 17^th October.

The stakes are higher if no deal can be done with regard to the debt ceiling.  While the partial shutdown of government can be seen as a bit of a nuisance, a government cash shortage could have global ramifications if it means that the government misses an interest payment on its bonds and thereby triggers a default.  Given that US government bonds are akin to another form of currency in the financial system, a default has the potential to bring the global financial system to its knees. 

In spite of this, the financial markets, while on edge, have not panicked - negotiations regarding the raising of the debt ceiling are still on-going, and even if a deal cannot be brokered, the effects are still unclear.  There are other sources of income such as money from taxes so the government will be able to keep up with some outgoing payments.  But that in itself creates another dilemma – which, if any, payments to forgo.  Investors would hope that debt payment would take priority over, for example, the payment of pensions.  Despite the potential consequences to the international financial system, it would take a brave politician to cut off pensions for old people.

Considering what is at stake, the consensus view is that the politicians will sort themselves out before the government is forced into making such choices.  Your Neighbourhood Economist would like to assume that this will be the case.  But the two main political parties have been squabbling for number of years with the situation getting worse rather than showing any signs of improvement.  Over the past few years, there have been skirmishes over a previous increase of the debt ceiling in 2011 as well as the negotiations regarding the fiscal cliff less than 12 months ago (for more on this, see Winning the election was the easy part) and one of the key obstacles to compromise is growing in strength – that being the so-called Tea Party portion of the Republican Party.

The Tea Party is the radical anti-government element of the Republican Party which is not afraid to be aggressive in pushing for a reduction in the size of government among other policies.  Its members in Congress are targeting large concessions from Obama to raise the debt ceiling – a position which is further fortified by Obama having conceded little in previous showdowns.  Perhaps the biggest concern is that the anti-government fervour of the Tea Party will translate into a view that the debt ceiling is an effective way of slashing government spending irrespective of the costs involved.

The Tea Party has found growing support among Americans disillusioned with the role of the government.  It is part of the rise of populist movements that can also be seen in Europe which rail against mainstream policies, such as an opposition to immigration.  The multi-party political systems in Europe can include such movements as separate parties which often struggle to get the necessary level of support to make it into government.  The political system in the United States only has two political parties and the Tea Party essentially controls a large portion of the Republican Party.  With voting districts in the United States having been shaped over the years to produce safe seats for either the Republicans or the Democrats, Tea Party candidates in Republican seats are typically better at whipping up support enabling them to win out over more moderate candidates. 

The Republican Party as a whole has increasingly felt the need to pander to this radical fringe which has brought a heightened level of conflict to US politics, within the Republican Party itself as well as between the two major parties.  Its unique system of democracy has been a key element behind the successful rise of the United States to global dominance.  But with the country’s place at the top of the global pecking order no longer assured (as described in A New Inconvenient Truth), it would be ironic if its political system was central to its downfall.

Eurozone crisis: Still bubbling away

The debt crisis in Europe seems a long time ago but a political hiccup in Italy shows that its revival may not be that far off.

Around this time last year, weeks would go by without this blog commenting on anything but the Eurozone crisis.  The turning point came near the end of 2012 with a bit of imaginative policy making by the European Central Banks who said they were willing to do “whatever it takes” to save the euro.  By the start of 2013, the worst seemed to be over (Good and Bad in 2013), but many of the problems still had to be fixed.  This year has seen the economic problems in Europe simmering away in the background rather than being likely to erupt as in 2012.  However, the turmoil in Italy at the moment shows that it does not take much for things to heat up again.  Europe may not dominate the headlines as in the recent past but it is never too far from the front pages and here is a look into why.

Politics in Italy are tricky at the best of times but an election earlier this year left the country with a fragile coalition.  A fresh saga was triggered as the constant distraction that is Silvio Berlusconi looked to pull his support from the government after being convicted of tax fraud in August.  Yet it was Berlusconi who suffered from his latest attempt at meddling as he was forced into a dramatic U-turn which involved providing support to the government in order to avoid seeing his own party rebel against him.  After a jump in the interest rate on Italian government bonds, the weakening of Berlusconi cheered investors as he had held sway over Italian politics for a long time despite Italy having not benefited much from his time in power.

Although Italy has avoided the unwelcome prospect of another round of elections, the problems that the country faces are greater than the immediate political woes (for some background, see Bigger than Berlusconi).  This year, the government budget deficit is expected to top 3%, which is the upper limit for EU countries, with government debt approaching 130% of GDP.  The coalition government lacks the political capital to push through the necessary reforms to get the economy moving ahead to help generate the tax revenues needed to reduce the shortfall in the government’s finances.

Italy is hampered by a problem which is typical for countries in Europe feeling the strain in the aftermath of the Eurozone crisis – voters weary of austerity measures with little to show for their perseverance.  Mainstream political parties who have been pushing government cuts have seen their support eroded by fringe parties which promise relief through policies which will have negative long term effects.  The democratic process has struggled to deal with the consequences of the economic slump and mounting debts following the global financial crisis.  Voters have been stuck with two unappetizing options – enduring the hardship of austerity with scant rewards or repelling against spending restrictions but becoming an outcast in the financial system.

The same themes can be seen being played out in Portugal and Greece among others.  Greece has witnessed the rise of the far-right extremist Golden Dawn party which has fed off the frustration of Greek voters.  Local elections in Portugal resulted in heavy losses for the ruling party who had pushed through austerity measures.  Despite all the hardship endured in these two countries, further bailouts are seen as necessary to deal with the stubbornly high levels of government debt.  The economic stagnation in Europe continues with countries like Greece still suffering with GDP down by 6.4% in 2013.  Portugal, Italy, and Spain among others also ended 2012 with lower GDP. 

While the European Central Bank has staved off the immediate threat of crisis, the flipside is that the pressure for reforms has eased.  As such, politicians can no longer blame the financial markets for their unpopular policies.  Leadership in Europe has also been lacking with the national elections in Germany drawing the attention of Angela Merkel away from Europe.  Coalition negotiations in Germany following the elections in September will leave Europe seemingly leaderless for a few more months.  The Eurozone crisis may have been put on the back burner but it could still boil over at any point if not watched.

Inflation – Then and Now

Inflation is driven by different factors now that the West is no longer the only engine of growth in the global economy but why might that be important?

Life is always better as the top dog, whether it be on the playground or at work. The same holds true for the global economy where large and growing countries have others banging on their door to offer whatever they might need.  As a result, the global economy shapes itself around the countries at the top of the pecking order and these countries benefit as a result.  One seemingly innocuous way this plays out is through inflation.  Inflation in Europe and the United States has always moved in tune with their economies due to there being no other significant sources of demand.  But the switch to a global economy with other major players has resulted in international commodity prices being driven by what is going on in other countries as well.  This means that inflation is not what it used to be.  And, if inflation is different, must monetary policy change as well?

Inflation is the economic phenomenon of increases in prices, where prices will rise if demand increases at a faster rate than supply.  Due to globalization, many goods are now traded on international markets and growth in the global economy will push up demand (and the price) for any goods.  While demand can fluctuate dramatically in a short period of time, changes in supply typically take time.  Prices which rise due to expanding demand as an economy grows may remain high as increases in production require more time to catch up.  This is not so much of a problem when an economy is growing as consumers will have more money in their pockets and won’t be as bothered by higher prices.  Thus, it is easier to accommodate prices rising at a faster rate when the economy is prospering. 

In the past, the main source of demand for most products came from Western economies (Europe and the United States) along with Japan, with inflation moving in line with economic growth in these countries.  The level of synchronisation between these economies was also high so that growth spurts came at the same time and inflation was typically timed to when the economy was ready for it.  But this all depended on there being no other big economies which were out of sync with the West.

However, the economic rise of China and emerging markets put paid to this convenient form of inflation.  The number of factors which determined global commodity prices had increased and the economy in China was large enough to move to its own rhythms.  China’s entry into the global economy was initially a boost for Europe and the United States in some ways with low-cost manufacturing helping to bring down prices at the beginning of the century.  Yet, economic growth in China did not slow with the onset of the global financial crisis and prices for many global commodities kept climbing higher as a result.

High inflation is never good but it is even worse when an economy is struggling to climb out of recession.  Rising prices during slow economic growth further depress spending and put pressure on profits at companies when times are already tough.  Being an open economy with few of its own resources, the United Kingdom has had to suffer through both a stagnating economy and high inflation.  For example, real GDP in the UK edged up just 0.8% in 2011 while inflation reached as high as 5.2% in September.  Yet, the Bank of England did not change its monetary policy to quell inflation in 2011 as it was clear that the origin of the inflation was overseas. 

However, the situation may not always be so clear cut.  And it is not the first time that inflation has been out of whack with what is going on in the economy.  Interest rates were kept down in the lead up to the global financial crisis as inflation was weak due to cheap goods coming in from China.  The lower borrowing costs spurred on the lending binge which accentuated the crisis.  Inflation was picked out as a gauge which reflects the strength of an economy but it is questionable whether that is still the case. 

Europe and the United States are already struggling to deal with the rise of new challengers (for more on this, refer to A New Inconvenient Truth) as well as the aftermath of the global financial crisis (see economy still stuck in a rut for more).  Shaping monetary policy around something which is influenced by external factors is not going to be helpful in steering clear of trouble.  And, inflation in itself is not enough of a negative for the economy to be managed for its own sake (go to time to rethink inflation?).  Monetary policy should instead look at other measures of economic health such as unemployment which is obviously something that needs to be lower (to a certain degree). 

A more relevant basis for monetary policy would help bring much-needed clarity with regard to the direction of monetary policy as we wait for the Federal Reserve to start the long process of ending its quantitative easing policy.  Central banks have a lot to answer for in terms of their role in the lead up to the global financial crisis and improving the way in which the economy is managed would go a long way toward making amends.

Quantitative Easing - Harder to End than to Start

The Federal Reserve changes tack on its change of tack in monetary policy which will make it less credible in the future.

It is still a month away from Halloween but something seems to be scared Ben Bernanke, the chairman of the Federal Reserve.  Bernanke was expected to announce that the Federal Reserve would be buying fewer bonds in September but surprised most pundits (including Your Neighbourhood Economist) by deciding not to make any changes with the status quo.  The unexpected bonus of a delay to the start of “tapering” helped push stocks in the United States to record highs but gains were limited by worries about the future direction of monetary policy.  By backing down from a change in policy, the Federal Reserve has made its job of finding an exit from quantitative easing more difficult while also making it trickier for investors to understand the big question that still remains – how far off is the beginning of the end for quantitative easing?

The Federal Reserve began to signal a change in direction in May and June using its own version of forward guidance where central banks outline future policy through using economic data as markers.  The current policy of the Federal Reserves has entailed buying US$85 billion in bonds each month with interest rates set at close to zero – its forward guidance in July put forward an end to bond buying by the time unemployment reached 7% with interest rates to rise once unemployment had fallen to 6.5%.  With unemployment expected to reach its first target by the middle of 2014, there was an anticipation that the Federal Reserve would move to reduce its bond purchases before the end of 2013, so as to ensure a more gradual decline in quantitative easing which would be less painful for the economy. 

Yet, investors drew their own conclusions from the forward guidance and took it as an excuse to sell bonds whose prices had climbed to record highs (for more, see Managing Expectations).  As lower bond prices translates to higher interest rates for bonds, the bond sell-off resulted in interest rates on benchmark US government bonds increasing from around 2% to close to 3%.  This ran contrary to the gradual adjustment which the Federal Reserve was attempting to facilitate to ensure that the nascent economic recovery would not be choked off by higher interest rates. 

The jumpy market reaction along with slower improvements in the US job market were enough to spook the Federal Reserve into keeping the quantitative easing going.  Only time will tell whether the cautious approach was the right call but Your Neighbourhood Economist fears that Ben Bernanke may have been too timid for his own good.  While there is always the possibility of gremlins lurking in the economy somewhere, the timing did seem as good as it will ever be for starting the drawn-out process of tightening monetary policy.

Unemployment in the United States has fallen to 7.3% in August compared to 7.9% in January (even though part of the fall is due to some people not bothering to look for work any more).  And, while the size of the market reaction was a tad overdone, investors always factor in events ahead of time – as such, the bond sell-off was just the normal response to an end to actions by the Federal Reserve which have propped up both the markets for bonds and stocks.  So, any further movements in the financial markets were likely to have been muted.  But as it happens, prices for bonds and stock perked up as investors looked forward to continued efforts by the central bank to prop up the markets.

With the Federal Reserve forgoing an opportunity to pare back its bond purchases in September, market participants are trying to figure out the possible timing for the inevitable change in policy.  The Federal Reserve meets again in October but will have few new bits of economic data to sooth its concerns over the strength of the economy.  The subsequent meeting of the Federal Reserve is in December with this seen by many as the next chance for action. 

The cautious approach by the Federal Reserve does have its costs.  It is a fad among central banks these days to signal in advance of changes to policy, but by choosing not to follow through with the expected change of policy in September, investors will be less likely to believe the Federal Reserve in future.  In the short-term, it is unclear what will be sufficient to trigger the beginning of the end of quantitative easing – weak economic data for the rest of 2013 may see the “to taper or not to taper” saga drag on for a while yet.  The resulting uncertainty and likely volatility in the financial markets may be even more harmful than the expected tightening of monetary policy. 

A central bank is only as good as its word and the Federal Reserve has cheapened its own words.  That is a scary prospect considering the current hands-on management of the economy by the Federal Reserve and how much it will have to do to talk its way out of this management role.

Beware of a Flood of Funds

Surplus cash in the global financial system has a history of leaving havoc in its wake and quantitative easing may be making the situation worse.

There is a lot of cash sloshing around the international financial system at the moment.  Central banks are still buying heaps of bonds and there are few places in the actual economy where people are willing to invest money.  Not having cash around in the financial system can make life very difficult as shown by the credit crunch where lending by banks ground to a halt and the global economy came close to collapse.  But too much cash in the financial system can cause its own troubles.  Cheap credit is one of the causes of the global financial crisis.  More recently, emerging markets have been tested by the coming and going of a massive tide of global funds.  What can be done to ensure that more of the world is not drowned in an excess of cash?

It may seem strange but there is a lot of spare cash around at the moment but no one wants to use it.  Companies are hoarding money as business people are not confident in being able to make money through new investments, and consumers are paying off debt while being worried if their jobs are safe.  Adding to this, banks are reluctant to lend as new regulations are prompting banks to be more cautious about the amount of loans on their books. 

Central banks have tried to alleviate this problem by making it cheaper to borrow, firstly, through reducing interest rates to close to zero, and when this has not worked, printing more money with which to buy bonds.  The bond purchases also serve to further lower borrowing costs, but businesses and consumers currently seem averse to taking out fresh loans no matter how cheap it is to borrow.  Nevertheless, the bond buying continues with the Federal Reserve alone buying US$85 billion in bonds each month.  The extra cash is not going into the actual economy as there is no demand for it and it is free to be moved to anywhere in the world.

So this money is not like a still pool of cash where money can be drawn as necessary, but rather more like a tidal system where funds will flow in one direction for a certain period of time before switching to another direction depending on the alignment of economic factors.  Any free funds will always move in search of higher returns and the flows shift as economic circumstances change.  The transient nature of the funds creates economic problems due to the temporary effect of lowering interest rates and creating a surge in lending, only for the money to flow out again at the first signs of trouble.  These flows of cash now dominate the world economy like never before and can leave havoc in their wake (for more, see Where is all the money going?).  

This ebb and flow of funds is given as one of the reasons behind the global financial crisis.  The size of the pool of cash had swelled due to a glut of savings in Asia which were invested in the United States.  The resulting lower borrowing costs spurred on excessive lending which extended to sub-prime loans, eventually causing the near collapse of the financial system.  Almost the reverse has been the case in previous weeks.  Extra cash generated by the bond purchases by the Federal Reserves and other central banks had found refuge in emerging markets which had continued to grow in the aftermath of the global financial crisis.  But the tide turned with the paring back of quantitative easing in the United States, which is expected to result in higher returns from investments in the US markets. 

The worst of the effects have been experienced by India, Turkey, and Indonesia who had grown more reliant on the money coming in from overseas due to imbalances in their own economy.  But emerging markets have shored up their defences after having often been caught up in the wash of global finances.  Countries with developing economies often build up large foreign exchange reserves which are used to counteract the outflow of funds (which was ironically behind the glut in savings in Asia seen as responsible for the global financial crisis).  The use of controls which restrict the movement of funds have also become commonplace and are even somewhat sanctioned by the IMF (who are typically ideologically opposed to any limits on the free movement of resources).  Even the new range of banking regulations in the United States and elsewhere, such as rules on higher levels of capital buffers, can be seen as a buttress against the swirling forces of global finances.

However, the new measures being adopted in developed countries and in emerging markets have the goal of merely preventing the symptoms of the problems created by the surplus funds.  Furthermore, foreign exchange reserves and capital buffers come with their own costs – this money could be put to better use when the economy actually needs the extra funds.  Would it not be better to deal with the problem itself?  Central banks could come up with a way of soaking up the surplus money in the world’s financial system.  Considering the global scale of financing, this might require a new role for an international organisation such as the IMF.  It would also involve a rethink of quantitative easing and the tools available to central banks since the freshly printed cash from central banks has added another deluge of funds and has created problems of its own (see Perils of doing too much for more detail).  It would be a sad day for economists if the aggressive policies from central banks to revive the economy from the latest crisis sow the seeds of greater instability in the future.  

Managing expectations as part of monetary policy

In trying to ease concerns about higher interest rates through forward guidance, central banks have ended up doing the opposite.

Managing expectations when you work with people in an office environment can be tough but imagine dealing with the multitude of global investors as well as the international press.  This is what central banks have to cope with.  Central banks have tried to provide greater clarity regarding the direction of monetary policy using forward guidance – linking changes in policy to improvements in economic data.  The plan was to ease concerns that monetary policy would be tightened too soon through fewer bond purchases and eventually higher interest rates.  But forward guidance instead triggered the selling of government bonds with investors now expecting tightening of monetary policy sooner than central banks are suggesting.  Why have investors reacted in this way and what might central banks do in return?

A change in monetary policy was always going to be a tricky proposition considering the influence that the central banks have built up over the markets due to their purchases of billions in bonds as part of quantitative easing (refer to Caution - Windy Road Ahead).  It all started with a statement by the Federal Reserve in the US in June that it was considering tapering off its bond purchases which currently amount to US$85 billion.  Any new policy initiatives in the US are predicated on the pledge by the Federal Reserve that interest rates will remain at their current low levels until there is substantial improvement in the labour market.  This is one version of forward guidance that has also been adapted by Mark Carney, the new governor of the Bank of England, who also linked future decisions on monetary policy to the unemployment rate in the UK (for more, see Same low interest rates but for longer).  The reasoning behind forward guidance is twofold – to assure potential borrowers that interest rates will stay low for a few years yet and to placate fears that tightening of monetary policy will hurt the nascent economic recovery.

Not much of a market reaction was expected from these announcements as central banks were signalling that changes to the status quo would be gradual depending on the state of the economy.  However, investors have reacted in a way that seems to suggest that tightening of monetary policy is imminent, that is, by selling off government bonds.  The interest rates on government bonds have risen from record lows and 10-year bonds issued by the US and UK governments have both reached close to 3% (lower bond prices due to selling results in higher interest rates on bonds).  Why did the markets respond in this way to seemingly innocuous comments?

Cautious investors had been big buyers of safe assets such as UK and US government bonds due to the weak state of the global economy coupled with the sovereign debt problems in Europe.  This had capped off a period where bond prices had followed an upward trend for a few decades, which is a long time in investment markets.  Higher bond prices had pushed interest rates to painfully low levels so the timing was ripe for investors to move their money somewhere else.  All that was needed was a trigger and this ended up being the statements on forward guidance.  It is as if the mere mention of the end of the current loose monetary policy got investors thinking that a bond sell-off was coming and that it would be better to beat the rush.

For holders of UK government bonds, data on the economy has added to the reasons to sell.  The OECD released economic forecasts in early September which predicted that the recovery in the UK would pick up pace faster than in other countries.  A potential housing bubble in the UK adds to concerns that the Bank of England will have to increase interest rates earlier than planned.  Mark Carney also left plenty of escape clauses in the forward guidance pledges which allows the central bank the freedom to act but gives rise to worries that interest rates will not stay low for as long as has been suggested.

The rebellion of the markets against the careful planning of the central banks does throw up a few issues.  Considering that both the US and UK have mountains of government debt, higher interest rates will translate through to greater limitations on government spending which, in turn, will hurt the economy.  The fortunes of the global economy have also taken a hit with higher returns on bonds prompting investors to repatriate money invested in emerging markets over the past few years when there were few other investment options.  But the rush of money leaving places such as India and Turkey has brought howls of protest as well as fears about the ramifications of the end of quantitative easing on international finance.

It is central banks that now have to make the next move.  Yet this could involve doing nothing.  The tightening of monetary policy was never going to be easy and the recent jumpiness of investors could be just seen as collateral damage.  This would be a prudent option if central banks believe that there is nothing else that they could do to dictate the directions of the market.  But, on the other hand, central banks may decide to wrest back control of the expectations of investors.  Such a course of action could be prompted by fears that interest rates on government bonds, which act as a benchmark for interest rates throughout the whole economy, are too high at a time when the economic recovery is just starting in earnest.  Since forward guidance has shown that mere words are not enough, central banks may have to act, possibly with more bond buying.  Such a shock would bring investors back into line and serve as a reminder not to second-guess central banks.  However, with central banks likely to be keener to step out of the limelight (for What's the rush?), investors are likely to be left to their own devices.