Euphoria vs. Anxiety

A heavy weight battle over economic policy and financial markets is brewing between the Bank for International Settlements (BIS) in one corner and the International Monetary Fund (IMF) in the other. Meanwhile the world’s major central banks may be lining up on one side or the other with the Bank of England (BOE) moving towards the BIS and the European Central Bank (ECB) drifting closer to the IMF. The Bank of Japan (BOJ), having embraced Abenomics, is ahead of the IMF.  The Federal Reserve appears to be seeking a neutral stance, but that could change with the next speech or testimony.

The BIS, the bank for central bankers, argues in its just released annual report that markets are a little too euphoric and giddy; that it’s close to the time when interest rates should be raised.  While the BOE may agree – it has already moved to slow down mortgage lending and rein in a housing boom before it gets out of hand – the BIS is clear that higher interest rates, not limits on mortgages are what’s needed.  Meanwhile, the IMF continues to worry that the expansion might stall and lead to deflation. The deep plunge in first quarter GDP in the US reinforced the IMF’s fears, causing them to cut their forecast of US growth for 2014. The ECB should be, and is, worried about deflation and may be preparing for even lower interest rates and its own version of quantitative easing down the road.

The BIS’s immediate target is to return some real risk to our ever-rising stock markets and remind investors that taking on more and more risk can lead to a bad end.  The BIS is removed from domestic politics in the countries whose central banks it serves; it is in a position to advocate policies like higher interest rates that could push stock prices down. Some of the other banks would find it harder to argue for raising interest rates and discouraging risk taking.

The Federal Reserve, like the other central banks, must be aware of the politics.  For the moment everyone is convinced that the Fed will raise interest rates in the middle of next year.  Until something changes this consensus, the Fed is likely to bide its time, continue trimming back on quantitative easing and watch both inflation and the financial markets.  Whether or not the 2015 consensus is correct, when rates go up, it will be a surprise and stocks will more than likely go down.  We may be safe for the moment.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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