Raghuram Rajan got it started. On Jan. 15, the governor of the Reserve Bank of India jolted traders on Mumbai's Dalal Street by cutting interest rates. The surprise was the timing of the announcement: Rajan wasn't supposed to deliver a policy statement for another 19 days.
The weirdness continued that same day—in Switzerland, of all places. For three years, the Swiss National Bank had steadily bought euros on currency markets to keep the country's franc from surging in value relative to the euro, and thereby choking off growth. Unorthodox, yes; but global financial markets had grown accustomed to the regular renewal of the bank's stance. Without warning, however, the Swiss cut the franc's tether. Swiss National Bank chairman Thomas Jordan also set the benchmark Swiss lending rate at negative 0.75%. In theory, a lower rate should put downward pressure on the franc; not enough in this case, as the franc's value shot up by 18% in the days that followed. Many hedge funds bled red.
And on it went. The Danes cut interest rates four times in the span of a few weeks. As this issue of the magazine neared deadline, China's central bank cut rates by a quarter of a percentage point and Poland slashed them by a half point. In the first 60 days of 2015, some 20 central banks had executed stimulus measures.
Let's call it the Great Central Bank Freak-Out of 2015.
The scale and breadth of intervention is reminiscent of the central bankers' manoeuvres during the 2008-09 financial crisis, with one big difference: There is no obvious emergency this time.
The central bankers who acted so boldly in the Great Recession say they are now responding to the startling collapse in oil prices. But since when was cheaper gasoline such a bad thing? The central bankers reply that, when you combine the plunging cost of energy with stagnant growth in major economies such as Europe and Japan, deflation has emerged as the clear and present danger.
Into this frenzy stepped Stephen Poloz. The Bank of Canada governor had the decency, at least, to wait until his regularly scheduled interest rate policy announcement on Jan. 21. The bank's benchmark rate had been set at 1% for more than four years, put in place by Poloz's predecessor, Mark Carney. Everyone assumed it would stay there. But Poloz shocked Canadian markets with a quarter-point cut. He called it "insurance" against the economic blowback from the fall in oil prices. The deterioration of wealth, he said, would be "unambiguously negative for the Canadian economy."
Poloz's counterparts all have similar explanations: Central banks are hard-wired to fight inflation or deflation, so what else are they supposed to do? But what if the world's central banks have developed a hero complex? Cheaper money works by tickling our greed. It tempts us to borrow, spend and invest.
That is what makes economies go around. The thing is, there is an emotion that trumps greed: fear.
The Bank of Canada was by no means enthusiastic about the Canadian economy's prospects at the end of 2014. Poloz made a point of underlining his dissatisfaction with the high number of Canadians who were either looking for work or in need of more hours. Still, things seemed to be crawling in the right direction. A weaker loonie and stronger economic growth in the United States looked likely to give exporters a lift. Statistics Canada confirmed in March that real gross domestic product grew at an annual rate of 2.4% in the last quarter of 2014, faster than the central bank reckons the economy can grow without eventually stoking inflation.
The bet on Bay Street at the end of last year was that Poloz would leave the benchmark rate unchanged for most of 2015 before starting a gradual trek back to higher rates. Growth conditions aside, the Bank of Canada was also clearly worried that Canadians were borrowing their way to a new financial crisis. In its policy announcement last Dec. 3, the bank noted that "household imbalances"—which is how it describes the country's record debt load—"present a significant risk to financial stability." The implication: Higher interest rates eventually would be needed to wean Canadians off their credit habit.
Seven weeks later, Poloz decided there was a more significant risk facing the Canadian economy than mass foreclosures. At a news conference on Jan. 21, Poloz explained that the sharp drop in oil prices at the end of 2014 was proving to be far worse than expected. By convention, the bank bases its forecasts on the current price of oil. In October, the cost of Western Canada Select was about $70 (U.S.) a barrel. When policy makers gathered to rethink policy in January, WCS had been stuck below $40 (U.S.) a barrel for weeks, which is nowhere near enough to cover the cost of extracting oil from sand in Northern Alberta. The bank has seen oil shocks before. Their statistical models gave them a good idea of where things were headed. Thousands of Canadians were facing certain unemployment. Oil companies already were scrapping plans to expand production, triggering a broader decline that would rob factories of orders and consultants of service contracts. There would be pain.
The bank focuses on something called the "output gap" to tell it how close or far it is from hitting its inflation target. The gap is the difference between actual GDP and the level of production the bank thinks the economy can manage before inflation accelerates too quickly. The goal is to get as close to the red line as possible. Last fall, the gap was narrowing. In January, it was getting wider.
Hence the rate cut, according to Carolyn Wilkins, senior deputy governor of the Bank of Canada. "That's why we decided to take out the insurance that we did, by cutting the rate, so that we could increase the chances that our projection, which is that we'll close the output gap by the end of 2016, will actually occur," Wilkins told me in late February, just before she and the other members of the bank's Governing Council went into a customary week-long blackout period ahead of the March 4 policy announcement. (In that announcement, Poloz left the overnight target unchanged. More on that later.) "Certainly from our point of view, doing the right thing with respect to monetary policy is the best way to maintain our credibility, because we'll be more likely to achieve our inflation target, but also that credibility should be something that underpins confidence."
Plenty of other experts disagree. Paul Masson, an adjunct professor at the University of Toronto's Rotman School of Management and a former adviser at Canada's central bank, says Poloz's notion of insurance was akin to unloading the cannons at the first sight of the enemy's flag. "'Taking out insurance' can take many forms, such as keeping your powder dry until it is needed," he says.
The chief executive of a Canadian company, who requested anonymity in order to speak freely, says he thought Canada's economic leaders were asleep at the switch. "My impression was that the Bank of Canada and the government were totally unprepared for a major correction in oil prices," the executive says. "They have been fixated on Canada as a petro-country and nothing more. Their reaction didn't seem to appreciate how volatile the Canadian dollar was and the violent correction will also have negative ripple effects."
The little-talked-about problem in-herent in this rush to the barricades by central bankers is that it sent a massive signal that we have reason to be fearful. "Who then would be bold enough to make a long-term commitment in such an environment?" wonders Stephen Lewis, an economist with ADM Investor Services International Ltd. in London.
Central bankers don't necessarily care about what the Lewises of the world have to say. The City of London and Wall Street types have been hurling those sorts of barbs for years. But what if the people who run millions of businesses—large and small, global and local—are rattled?
The bank needs to keep the confidence of entrepreneurs like Mark Hanna, a partner at Montreal-based Leeza Surfaces Inc., which supplies stylish, high-end countertops. The company is headquartered just north of Pierre Elliott Trudeau International Airport, and has warehouses in Toronto, Vancouver and Connecticut. I first met Hanna at a forum for entrepreneurs in Ottawa in August, 2009, near the end of the Great Recession. He was weathering the crisis well, and he was optimistic.
But when I contacted Hanna this past February, after Poloz's surprise rate reduction, he was spooked. "The cut in rates, to me, suggests desperation," he said. "This does not instill confidence when I think about our economy." The trouble for central bankers is that there are lots of Mark Hannas out there—in every industrialized country. He is an honest-to-goodness economic actor: a hirer of people, a customer for loans. He is the kind of person the central banks are trying to help, yet they've shaken his desire to expand his business. So why the Great Freak-Out?
In the old days, central bankers tried to avoid volatility—or creating excitement of any kind, really. They were the stoic guardians of our economies, detached from the fickle political calculations of governments and immune from the base profit motives that drive corporate leaders. Alan Greenspan, who was chairman of the U.S. Federal Reserve from 1987 to 2006, was the archetype of the abstruse central banker. His long, elliptical responses to questions from U.S. legislators, delivered in a monotone, were quite deliberately opaque. "I should warn you," he once joked, "if I turn out to be particularly clear, you've probably misunderstood what I've said."
Yet Greenspan, oddly, was easy to read when it came to what the markets cared about most. He liked to adjust interest rates in predictable, quarter-point increments, so when he started down a path, investors and traders knew where they were headed. The Greenspan years came to be known as the Great Moderation.
There was nothing moderate about monetary policy during the financial crisis and its aftermath. Ben Bernanke, Greenspan's successor, and the heads of the rest of the world's major central banks, acted boldly and massively. They slashed interest rates—to 1% in the euro zone, and near 0% in the United States and Japan. The Fed, the Bank of England and the Bank of Japan also launched huge quantitative easing programs that lasted for years—essentially creating hundreds of billions of dollars worth of currency to buy government bonds and other debt securities, thereby injecting cash into banks that could be loaned to businesses and consumers.
The politicians did their part, too—at first. They ran massive budget deficits to stave off another Great Depression. Even Canada's resolutely tight-fisted Conservatives cranked up infrastructure spending and racked up a $56-billion deficit in the 2009-2010 fiscal year, and a $33-billion shortfall in 2010-2011. But since then, to varying degrees, governments have shifted back to austerity. The Group of 20 got out the fire hose when the world was on fire, but they didn't stick around for the rebuild.
That austerity is now an anchor on growth. The U.S. recovery has picked up momentum over the past year—in part because state and local governments are spending again—but the American economy is the exception. Even growth in China is slowing. Japan remains mired in a slump that, in many respects, has lasted since the 1990s. Much of Europe is flirting with deflation and a triple-dip recession.
In contrast to governments, the central bankers have kept stimulating since the financial crisis. Denmark pioneered the use of negative interest rates in July, 2012, when its central bank lowered the deposit rate on funds it holds for commercial banks to -0.2%, to encourage those banks to loan the money instead of hanging onto it.
All along, of course, many analysts have questioned how effective the low, low rates and all that E-Z money have been. Some argue that the central bankers have done little more than fuel asset price bubbles, lining the pockets of the well-to-do, but few others. The U.S. stock market has almost tripled since the bottom in 2009. Apartments in New York have cracked the $100-million barrier, and in London, they've soared beyond $200 million—asking prices, at least.
Closer to home, average prices for a detached house in Vancouver or Toronto have soared above $1 million. The University of Toronto's Masson wrote a paper in 2013 that pleaded with Carney to raise interest rates. He says that Canada's lacklustre economic growth since then hasn't caused him to change his mind. A massive run-up of debt caused the financial crisis. History could be repeating itself.
Central banks understand the risks. They simply are unwilling to put theoretical concerns ahead of a threat that is staring them in the face. Deflationary pressures last fall pulled the big central banks in various directions. After injecting more than $3.5 trillion (U.S.) into the U.S. economy following the financial crisis, the Fed ended its regular monthly purchases of bonds and mortgage-based securities in October. That was the Fed's nod to those who accuse it of sowing the seeds of the next crisis. But Janet Yellen, who replaced Bernanke in February, refused to signal when she might raise the official rate from zero. In September, Mario Draghi, president of the European Central Bank, lowered the ECB's benchmark rate by 10 basis points to 0.05%, and its deposit rate to -0.2%. He also promised that the ECB would soon unveil a massive QE program of its own.
Then, another wild card began creating more headaches for central bankers.
A week before Poloz's dramatic interest rate announcement, Timothy Lane, one of four deputy governors of the Bank of Canada who sit with Poloz and Wilkins on its Governing Council, gave a speech at the University of Wisconsin in Madison. The title was clear enough: "Drilling Down—Understanding Oil Prices and Their Economic Impact." The text was released online and, toward the end, Lane declared that lower oil prices would be "bad for Canada."
If that was meant as a warning, most analysts and commentators missed it. The bank rarely sent messages via its deputies, so few—if any—market participants would have been giving Lane their full attention.
Besides, there were no other reasons to expect any surprises.
After Poloz succeeded Mark Carney in June, 2013, he made a point of easing his way into his new role at the centre of the Canadian economy. He kept the bank's benchmark rate at the 1% set in September, 2010, allowing the memory of Carney's dramatic moves during the financial crisis to fade away. No more adventures in monetary policy—Poloz was fond of telling audiences that the time had come to let "Mother Nature" do her work.
No wonder Poloz sounded almost apologetic when he met with reporters after his rate cut. "We generally prefer that markets not be surprised by what we do," he said. "We took comfort from the observation that the consequences of the drop in oil prices appear to be well understood, and that the possibility of a rate cut had begun to enter markets in the last couple of weeks." Or maybe it didn't. The Canadian dollar plunged by more than 1.5 cents (U.S.) that day, closing at 81.07 cents, its lowest level since April, 2009.
The Bank of Canada's leaders are clearly sensitive to the possibility that monetary policy could actually undermine confidence, rather than bolster it. But in January, they decided to risk it. Wilkins insists that they knew what they were doing. A quarter-point interest rate adjustment is the type of fine-tuning that the bank used to do all the time. "It's a bit of a stretch to say that a 25-basis-point cut in a policy rate is a panic reaction to a 57% decline in oil prices since last June," she said.
That oil price collapse is more of a problem for Poloz than it is for central bankers in Europe and Asia. All of the bankers are worried about the deflationary impact on consumer prices. Poloz also has to contend with the impact on output and employment in the Alberta oil patch, and on the companies that supply and finance it.
In some ways, Poloz's job is much trickier than Carney's was during the financial crisis. Carney had the aid of Jim Flaherty's expansionary fiscal policy, but now the Harper government is determined to balance the books before the election this fall. On the day that Poloz cut interest rates, Finance Minister Joe Oliver said there was no need for a matching response from him. "We think it's wrong to burden our children, our grandchildren with expenditures that we're incurring today, so we think a balanced budget is important and we're going to achieve it," he said in a broadcast interview with CNBC at the World Economic Forum in Davos.
Oliver would be correct if it still was the 1990s, when Canada was facing a debt crisis. Now, Canada is one of the few countries with a triple-A credit rating. The federal deficit is so narrow—less than 0.5% of GDP—that it hardly matters whether the government balances it or not.
The provincial premiers aren't helping Poloz much, either. Bank of Canada economists estimate that the total portion of GDP growth this year attributable to all levels of government will be 0.2 percentage points. In 2006, that figure was 0.8 percentage points. I asked Wilkins if the January interest-rate cut would have been necessary if current government spending was at pre-crisis levels. She dodged the question. "We take fiscal policy as a given," Wilkins said.
Compared to what the ECB's Draghi announced on Jan. 22, Poloz's rate cut looked like a blip. Draghi unveiled a ¤1.1-trillion quantitative easing plan that would have the ECB co-ordinate purchases of ¤60-billion worth of securities a month until September, 2016. Investors were ready for QE, but not on that scale. Britain's Guardian newspaper described it as "shock and awe." The plan kicked the Great Freak-Out into the stratosphere.
In many countries, official interest rates are now lower than they were during the financial crisis. The Danes, the Swiss, the ECB and the Swedes all are experimenting with negative interest rates. In effect, they are challenging hedge funds and banks to find more productive uses for their money than financial speculation.
At least some investors are encouraged. U.S. and Indian equity markets have scaled new heights this winter. "The accommodation should result in a positive wealth effect via higher equities and bonds," Ankur Patel, chief investment officer at R-Squared Macro, an investment firm based in Birmingham, Alabama, told me. "These co-ordinated global rate cuts, zero-interest-rate policy, and QE may be what ultimately provides a net positive boost to confidence."
Yet the usual doomsayers and conspiracy theorists—and the Internet is full of them—are predicting disaster: We are headed for a devastating global currency war, reminiscent of the 1930s, when central banks slashed exchange rates in an attempt to ignite their countries' exports. But when those competitive devaluations were combined with beggar-thy-neighbour trade restrictions, they only aggravated the Great Depression by reducing global demand for goods and services.
The suggestion that central banks are trying to beggar one another like they did in the Great Depression is highly debatable. Yes, the exchange rate is one of the channels through which a central bank influences inflation. And when interest rates shift, capital diverts to countries that offer the highest return. With so little demand in many countries to offset the upward pressure on exchange rates, they have little choice but to keep lowering rates in order to hit their inflation targets. The adjustment is more mechanical than predatory. "It is not so much a currency war, or anything malicious, but the mere fact of lack of co-ordination," says Vivek Dehejia, an economics professor at Carleton University who currently is working on a research project in Mumbai.
Dehejia has a point. The world's central bankers this winter looked like soldiers awakened in the middle of the night to fight an unknown enemy. If there was no grave emergency, then surely someone should have said so. But who? That was part of the problem. There is no one.
The most powerful central banker in the world is Janet Yellen. She has a reputation as a communicator. Yet the Fed's messages have been anything but clear.
This past February, Yellen tried to cool speculation that the Fed's policy committee would raise the target range of its benchmark rate—now between zero and 0.25%—any time soon, or even hint that it would. "If economic conditions continue to improve, as the committee anticipates, the committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis," she said. "Before then, the committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the committee will necessarily increase the target range in a couple of meetings."
She sounded like Alan Greenspan.
In theory, negative interest rates and years and years of ultralow interest rates should work just fine. Unless, of course, executives and investors look at a negative interest rate and decide nothing good can come of a policy that appears to defy reason.
Ben Bernanke always warned that monetary policy wasn't a panacea. We finally may be witnessing what he meant. After the scramble of January and February, the weeks and months ahead will determine whether monetary policy still has any pop.
Which brings us to the Bank of Canada's most recent interest rate announcement. On March 4, Poloz performed another stunner—this time by doing nothing. Financial markets had priced in another rate reduction. There was grumbling about Poloz sending mixed signals. There is a real risk that central bankers could be losing the public trust. And if that is true, they just made things worse.