Once upon a Time There Was an Economy Surprising Us with Its Strong Recovery

October 6 2015

What a remarkable month it has been in terms of monetary policy! The three most important central banks in the Western world, namely: the U.S. Fed, the European ECB and the British Bank of England, met to discuss interest rate policy. After viewing the accompanying press conferences and press statements, I noticed something remarkable and simultaneously worrisome.

The ECB has decided to maintain its policy rate at 0.05 percent, and will continue with printing 60 billion euro every month to overload the financial markets with cash. Their intention is to boost economic growth and inflation. For the same reason, the British central bank and the Fed decided to keep their policy rates unchanged; 0.5 and 0 percent in the U.K. and U.S. respectively.

You might be wondering whether that is actually remarkable. No, it certainly isn’t. But something else is. During his press conference, after the governing council meeting, ECB President Mario Draghi stated that “The information available indicates a continued though somewhat weaker economic recovery.” And although this year’s (as well those concerning 2016 and 2017) predictions have been adjusted slightly downwards, the ECB still assumes that the Eurozone economy will grow with 1.4% this year. They further expect that the economy will grow even stronger in 2016 and 2017, with respectively 1.7 and 1.8%.

The Fed stated that “information received since the Federal Open Market Committee (FOMC) met in July suggests that economic activity is expanding at a moderate pace.” The Fed Chair, Janet Yellen, even mentioned that the FOMC 'was impressed' by the economic recovery in the US. The central bank also mentions that it “sees the risks to the outlook for economic activity and the labor market as nearly balanced.” Or in other words, the U.S. economy seemingly continues its growth despite China’s slowdown. In London, the British monetary knights said that “Private domestic demand growth was forecast to be robust enough to eliminate the margin of spare capacity over the next year or so, despite the continuing fiscal consolidation and modest global growth.” While China’s slowdown of economic growth may have adverse effects on the British economy, strong domestic demand will neutralize a large part of it, or so says the Grand Old Lady between the central banks, the Bank of England.

Why is all of this remarkable? All of the above indicates that the U.S., British, and Eurozone, economies are on a safe distance from a recession.  

The last time that this occurred, the central banks’ interest rates were miles above 0, 0.05 and 0.5 percent; they have been at that level for years now, and, based on the policy decisions made this month, are expected to remain there for the time being. Or even more troublesome, the head economist of the British Central bank has mentioned that further lowering the interest rate might be necessary. Furthermore, within the FOMC there is at least one committee member who argues for negative policy rates, while the ECB also clearly stated they were ready to print more than 60 billion euros a month if deemed necessary.

If you look at the current state of affairs in the British, U.S., and Eurozone economies, and the current interest rates set by the central banks, and subsequently look at the outlook for growth (continued, robust) and the monetary policy (expansionary, possibly even more so), it doesn’t make a lot of sense.

If economic growth in all three jurisdictions is really relatively high, and will remain so, despite setbacks such as the economic slowdown in China and other emerging markets, then we must ask ourselves why the central banks are desperately trying to keep their policy rates at (nearly) 0 percent, and why they continue to print money. The Fed referred to 'uncertainty in economic and global developments' as a reason to keep its policy rate at 0 percent. But the economy is always confronted with uncertainty, and if we would take that reasoning to its logical conclusion, the Fed might as well close its doors and just forever hold its policy rate at 0 percent.

Given the economic developments and positive future expectations in all three aforementioned economies, why are its central banks scared to raise their policy rates from emergency levels (0 percent)?

There are three potential explanations, and all three are worrisome. The first explanation comes from the fact the central banks are afraid to raise interest rates, which may imply that the current economic growth is artificial. The patient might be walking, but only because he has crutches, otherwise he would fall on the floor immediately.

The second potential explanation is an extension of the first one; under the surface, the economic state of affairs is much worse than the official figures which tell us the optimistic, comforting story repeated by the central banks. This would be a legitimate reason to keep their monetary policy unchanged, but would also mean that we’re being told a fairy story about the current state of our economies.

The third potential explanation is that the central banks, using their powerful monetary policy, are supporting the financial markets because they’re scared that prices will drop. But if that is the case, it would mean they serve the wrong interests; instead of serving the greater public, as they are supposed to, they would be serving the interests of the financial sector.

Whichever of the three it is, they are all concerning. In the first possible explanation, the conclusion is that everything that central banks have done since 2008 – and that’s quite a lot – hasn’t helped us at all. And if they nonetheless continue it, doing more of the same, it would remind me of Albert Einstein’s famous definition of insanity. He defined it as “doing the same thing over and over again and expecting different results.” In the second case, we are being fooled by fake optimistic stories. And if the third explanation is true, then central banks aren’t doing what they’re supposed to be doing.

What the Fed and other central banks have done last month is best compared to a hospital admitting a patient to its intensive care after a serious accident, then declaring the patient healthy, but not discharging him from the hospital. While the patient is on a drip and several other devices, members of immediate family aren’t exactly convinced that the patient has recovered from its life-threatening condition.


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