Central bankers and the great savings battle

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You can smell a rat when grim-faced government officials - once almost-anonymous governors of national central banks - appear to become the promoters, and even superstars, of global financial markets.

It never used to be like this. William McChesney Martin, chairman of the US Federal Reserve in the 1950s and 1960s, famously remarked that it was his job "to take away the punch bowl just as the party gets going". The US Federal Reserve would tighten money to choke off an inflationary economic boom and its associated Wall Street equity bull market. Central bankers were killjoys.

The toughest of all was Paul Volcker who, as Fed chairman under Ronald Reagan in 1980, cranked up the Fed's short-term interest rate to more than 17% at one point to kill off the inflation that had dogged the whole of the 1970s.

How different it is today. This year Wall Street has been relying on the current Fed chairman, Ben Bernanke, to continue pumping loose money into the financial markets by purchasing financial assets - a process dubbed quantitative easing (QE) - and thereby sustain an equity market bubble. He has become a market hero.

Our very own Sir Mervyn King, the retiring governor of the Bank of England, made a celebrity appearance on the BBC's Desert Island Discs radio show. Wisely he did not choose "I'm Forever Blowing Bubbles" as one of his eight discs. Perhaps he should, instead, have selected an ominous passage from Götterdämmerung; we may be entering the twilight of the age of central bankers.

Are the new breed of central bankers at risk of losing control?

Tough-guy central bankers:

William McChesney Martin

In the 1950s and 1960s the US Federal Reserve chairman said it was his job "to take away the punch bowl just as the party gets going".

Paul Volcker

The Federal Reserve chairman under Ronald Reagan cranked up the interest rate to more than 17% in 1980 to kill off the inflation that had dogged the whole of the 1970s.

Not-so-tough-guy central bankers:

Alan Greenspan

In the 1990s Wall Streeters relied on the Fed's Greenspan to cut interest rates when share prices weakened.

Ben Bernanke

Wall Street has been relying on the current Fed chairman to pump money into the financial markets and sustain an equity market bubble.

Haruhiko Kuroda

When prime minister Shinzo Abe ordered his new central bank governor to begin an aggressive QE programme, the long-moribund Tokyo stockmarket suddenly sprang into life. But the dangerous bubble-like nature of such QE manifestations has now become clear.

Sir Mervyn King

The retiring Bank of England governor wisely chose not to pick "I'm Forever Blowing Bubbles" when he appeared on Desert Island Discs.

Mark Carney

George Osborne cannot call in the US Cavalry to save the UK economy. Maybe a Mountie can do the job.

Sir Mervyn's successor from the beginning of July is Mark Carney, hired by the Chancellor, George Osborne, as a superstar central banker from Canada. Osborne cannot call in the US Cavalry to save the UK economy, but maybe a lone Canadian Mountie will do the job instead.

Transforming stockmarkets

The sheer power of central bankers to transform the performance of stockmarkets became clear in the early part of this year in Japan. Last December the newly elected prime minister of Japan, Shinzo Abe, ordered his new governor of the Bank of Japan, Haruhiko Kuroda, to begin an aggressive QE programme. The long-moribund Tokyo stockmarket sprang into life.

Between mid-November and late May the Nikkei 225 index put on an amazing 80%. Unfortunately, the dangerous bubble-like nature of such QE manifestations has become apparent, and the Tokyo market crashed by more than 7% on one day alone, 23 May, causing negative reverberations around the world. Moreover, the Bank of Japan's strategy has caused the Japanese yen to slump on foreign exchanges.

Once it was the job of central banks to stabilise economies. Now it appears to be their task to pump them up. Why has this change happened? Essentially, it is because national treasuries have become buried in debt and are no longer able to stimulate economies through fiscal policy (that is, through changes to taxes and spending). Accordingly, they have called on their central bankers to step forward into the limelight from their remote back rooms. They must develop exceptional new strategies to provide economic stimulus.

We began to notice this at the Fed, under Alan Greenspan, in the 1990s. Deflation was being imported as cheap goods flooded in from China and other developing economies, and US domestic inflationary pressures therefore eased, giving the Fed room to run unusually easy monetary policies. Indeed, Wall Streeters began to rely on Greenspan to cut interest rates every time share prices weakened.

But under this stimulus the global financial markets entered a bubble-prone period. In the 1990s the asset class mostly affected was equities. By 2000 stockmarkets were hugely overvalued and heading into an inevitable crash. Then, during the first decade of the 2000s, the bubble was transferred to property, both commercial real estate and residential dwellings. Between 1997 and 2007 house prices tripled in the UK.

When that bubble burst a general financial crash ensued, largely because of losses on mortgages and associated derivatives. The central banks responded by pumping out hundreds of billions of dollars.

The bubble shifted again, this time into fixed-interest bonds. For cash-hungry governments, not least in the UK, the fall in the cost of borrowing has provided a welcome bonus. But there is increasing fear of new crashes in the months ahead - in emerging market debt and low-grade corporate bonds, for example.

War on savers

The central banks have embarked on a war on savers. True, savers benefit from high financial asset prices. But they have become exposed to abnormally high volatility and downside risk. Prudence has gone out of the window.

In the past central banks have set short-term interest rates with regard to a reasonable balance between the longer-term interests of both depositors and borrowers. Even in the 1930s the UK's bank rate never went below 2%. That restraint has now disappeared, however. The bank rate has been only 0.5% for several years now and the Bank of England is in the process of destroying the traditional savings deposit market by operating the so-called Funding for Lending Scheme (introduced a year ago). This gives banks access to ultra-cheap money.

Governments are desperate for quick fixes to boost growth and they see savers as easy targets - although thrift cuts gross domestic product in the short run (it raises it in the long term by financing capital investment). Nowhere is this short-term growth obsession more obvious than in the UK, where George Osborne desperately needs to fuel a decent rate of GDP in the period of less than two years that remains before the scheduled May 2015 election.

Pumping up the stockmarket may help boost economic confidence and therefore activity. And the debt-stricken British government may be able to unload some of its unwanted baggage for cash, such as its holdings in struggling banks such as Lloyds Banking Group (LLOY) and Royal Bank of Scotland (RBS), not to mention Royal Mail - please tell Sid, or even Postman Pat.

Moreover, rising house prices would have an even bigger impact, because a much higher proportion of the voting population would benefit, which is why the government has brought in measures blatantly intended to encourage a new house price bubble, which is already beginning to inflate in favoured locations such as London.

Enormous challenges

Savers and investors clearly face enormous challenges. I will define savers here as people (mostly fairly young) who want to build up resources, including a pension pot, and investors as mostly older people managing their existing portfolios.

Savers face the biggest problems. Indeed, saving may have become a mug's game, at least for the time being. Investors are slightly better off so far, because asset prices have been firm, but they are short of income and face the worry that their risks are becoming greater than they have been through most of recent financial history.

So far so good: the stockmarket has been strong this year, and equity bull markets always have to climb a wall of worry. But this time it has been more like a wall of disbelief. After all, the economic news is fairly dismal, especially in Europe. Company profits have held up surprisingly well because the real squeeze has been felt by employees. The higher company profits rise, however, the less reason there is to hope that shares are undervalued.

The starting point for investors is that it rarely pays to bet against powerful central banks. The short-term strategy is therefore to go with the flow. As long as the central bankers continue with QE, we should stay with bonds and equities. There are opportunities for borrowing cheaply, not least in the UK, though if we borrow to invest in property we will be buying into the early stages of a potentially dangerous and shortlived house price bubble.

But we can see from what has happened recently in Japan that QE strategies are not reliable. Equity volatility in Tokyo has turned out to be problematic and Japanese government bond prices have wobbled quite badly too. Securities market analysts all over the world are agonising about the possible risks. How long will the major central banks continue to pursue their recent policies? And what might happen when they call a halt to QE and then - worse - seek to reverse it?

This delicate subject was tackled in April by the International Monetary Fund in a paper entitled "Unconventional Monetary Policies - Recent Experience and Prospects". The paper warned: "A future tightening of monetary policy is likely to be bumpy."

The Bank of England, in particular, would face huge capital losses on its £375 billion QE portfolio of overpriced gilt-edged bonds as yields climbed to a more normal level (though the UK Treasury would pick up the tab). "Central banks will enter a phase of largely uncharted waters," the IMF paper added. That is scarcely a comforting prospect for personal investors.

Dash from cash

We have experienced what might be called a dash from cash for several years as investors have rejected the negative real yields on deposits. But might we soon need to engage reverse gear and embark on a flight from crash to cash, as the central bankers struggle to keep control?

Sir Mervyn King, with his eight treasured discs, will be out of harm's way, leaving Mark Carney in the hot saddle in Threadneedle Street. Ben Bernanke is due to retire as Fed boss next January. The European Central Bank has its own dire problems as it seeks to hold the crumbling eurozone together. Central bankers everywhere are at risk of losing control.

There will be no safe hiding places. The recent tumble in the gold bullion price showed that assets that seem to provide protection against the recklessness of central banks can, nevertheless, suffer sudden speculative sell-offs. Gold still has attractions for the long run, but it will always be a volatile asset.

The basic rules of portfolio management in a crisis are straightforward. Cash is the safest asset in the short run. Equities can slump in price temporarily but will recover in the long run. Fixed-income bonds carry different risks: when they are under German influence (in the eurozone) the main danger will be of "haircuts", or Greek-style writedowns of redemption values.

But in the UK or the US, inflation or currency depreciation may be more damaging. Government inflation-protected bonds can be tossed into the mix as useful diversification. What is tricky, though, is getting the timing right.

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