The days when central banks used to tweak interest rates from time to time either to fend off the risk of inflation or to boost demand have long gone.
nterest rates have been at zero or negative across a fifth of the world’s economic output for well over a decade. The eurozone and Ireland will ‘celebrate’ a decade of negative rates in 2024 and on current trends rates may not start to lift from a negative 0.5pc until the following year.
Given that there’s been nowhere to go on with rate cuts, the European Central Bank has flooding markets with money by buying government and other bonds. It owns €7.7trn of sovereign debt, the equivalent of nearly 80pc of the eurozone’s annual economic output – or put another way, equal the GDP of 20 Irelands.
Back in 2005, the ECB owned around €1trn and in 2012, it was a touch over €3trn. Now, it and central banks across the world are the buyers of first resort for government debt, as well as setting the cost of borrowing.
At her press conference today, Christine Lagarde will do all she can to avoid talking about when this will all end.
The ECB calculates that had it not been for negative rates, its bond buying and the guidance it gives to markets, growth in the eurozone by 2019 would have been 1.1 percentage points lower and the unemployment rate 1.1pc points higher than the actual outcome, which let’s remember wasn’t great.
In 2020, it says this package reduced 10-year sovereign yields by more than 250 basis points [100th of a percentage point].
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It’s hard to prove a counterfactual, but Italy hasn’t gone bust, so by that crude measure alone, it has worked.
The question now, is how to keep on going? Economies across the world are roaring back into life as lockdowns ease and people get vaccinated, even in the eurozone, and there’s a strong whiff of inflation about the place – something we haven’t seen in decades.
There’s a decent argument to be made that if your fiscal stimulus doesn’t cause inflation, it is simply not big enough.
Low interest rates have also fuelled massive financial market leverage. Shares are at all-time highs, house prices across the world are surging and even fundamentally worthless assets like Bitcoin have been on a tear.
Each time a central bank starts the process of talking about its portfolio, there are ructions, from the Federal Reserve’s ‘taper tantrum’ of 2013 to the September 2019 market meltdown prompted by the Fed’s decision to reduce its balance sheet by just $700bn.
At least the Fed engineered a take-off that pushed the US to full employment and managed to jemmy interest rates up to 2.5pc. It had room to cut rates as we went into Covid and its holdings of bonds relative to US GDP are less than half the ECB’s.
The ECB’s poor record in the financial crisis goes beyond two rate hikes in the teeth of recession, it also shrank its balance sheet by a third from 2012 to 2014, effectively baking in the low inflation that has plagued the eurozone.
In 2018, the bank also moved to end bond purchases.
It has managed better this time, but those earlier failures and Europe’s fiscal design means there has been a cost. It is going to keep running its pandemic bonds programme – €18bn a week – into next year. Once that drops, it looks set to double another programme.
If that inflation bump turns into something more permanent, the ECB will face an unpleasant choice between causing pain to eurozone governments by hiking rates, or risk losing control over prices.