Are there free lunches for central banks?

In the developed world, the talk is one of still rising interest rates. From time to time, greedy investors push out stories that one central bank is finished tightening or that it would ease in the second half. In the wake of a headline on US retail sales data for February, a research house pushed the theory that the Federal Reserve Board members were about to terminate the cycle of rising short rates.

Financial markets took that to heart as it augurs well, at least in the short-term, for asset prices. Investors chose to ignore the significant upward revision for retail sales in January and also chose to ignore that the core consumer price inflation rate remained at 2.1% in February. In other words, investors are looking to continue to revel in the low-interest rate, high liquidity environment of the past two to three years to support financial and real asset prices that are either fairly or overvalued.

Central bankers themselves appear confused and, in the process, are keeping the hopes of the greedy alive. In the US, Chairman Ben Bernanke, in a recent speech, kept his options open on whether the low level of long-term interest rates was a sign that the Federal Reserve needed to do more at the short-end or that it signalled a global structural downshift in the level of interest rates due to excess savings in relation to investment. In the UK, the Bank of England cut interest rates once last year and since then, the housing market had bottomed out and begun to rise. Growth in home prices has picked up again and mortgage approvals held at a 20-month high in January.

These institutions appear to be caught between reacting to low inflation on the one hand and reacting to rising asset prices, low consumer savings and higher trade deficits on the other. Only two central banks have been consistent in their stance with respect to asset prices. They are the European Central Bank (ECB) and the Reserve Bank of New Zealand.

The ECB has begun to push interest rates higher this year although many question their aggressive rhetoric in the light of what they see as the fragile foundations of recovery in the leading European nations such as Germany and Italy. Furthermore, the economies of Greece, Spain and Portugal have been driven by gains in real estate prices. Hence, some are concerned that the Eurozone economic recovery might be derailed if rising interest rates cut into the bubble in real estate in the Mediterranean economies.

However, that is precisely what the ECB is thinking except that, it reckons, if left unchecked, the bubble would grow bigger and any decline from even higher levels of asset prices would be even more painful.

Somewhat similar is the logic of the Reserve Bank of New Zealand, where the governor has been even more vocal about asset prices influencing the central bank?s rate decisions. Despite signs of the economy cooling off and business confidence dropping, he has kept interest rates high to ward off a speculative bubble in real estate prices in the country.

It is going to be interesting to see which of the countries manage to maintain growth with macro-economic stability over the next five years. If the Eurozone and the New Zealand economies fare relatively better on the above criteria than the rest, then the case for being somewhat pre-emptive on asset prices would be strengthened. Put differently, if the Eurozone and New Zealand defuse asset price speculation without choking growth, their central banks would stand vindicated.

To be fair to the central banks, one must acknowledge the tricky choices they face. It is difficult, if not impossible, to target rising asset prices in democracies. Rising asset prices engender a ?feel-good? factor and boost the ratings of incumbent governments. Hence, politicians would be ill at ease with a central bank targeting asset prices.

On the other hand, with globalisation on track, inflation rates are influenced by the availability of global capacity for production and labour for employment. Hence, inflation rates are unlikely to rise as much as they used to in previous economic cycles. Further, globalisation feeds directly into corporate bottom-line as it holds down production and labour costs. A combination of low interest rates, due to low consumer price inflation and higher profitability, results in a rationally optimistic outlook for prices of stocks and other risky assets. However, boosted by the ability of the financial system to generate liquidity, asset prices quickly take on a momentum of their own and become unhinged from the underlying fundamentals. Globally, asset prices are heading in that direction and some are there already.

While economic risks to this heady combination of low interest rates and rising asset prices might appear remote now, current asset price levels in Emerging markets and in commodities leave no room for any negative shock from other sources of risks such as politics, security or health. If any such risk strikes this year, the resulting fall in asset prices could dull investor risk appetite for many years, undoing the global economic recovery of the last few years.

In a way, just as investors have been told (and yet they forget) that there are no free lunches, central banks might have to ponder if there are no free lunches in managing an economy. Hard-fought and won economic stability through a war waged on cost-push goods and services inflation may soon be surrendered to volatility caused by boom and busts in asset prices. Therefore, a sense of urgency is required in arriving at an intellectual consensus for incorporating asset prices into the monetary policy framework. Otherwise, arriving at the scene only to mop the mess after a failed boom would neither be satisfactory for central banks nor enhance their credibility.

The writer is the founder-director of Libran Asset Management (Pte) Ltd, Singapore. These are his personal views