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Central Bank Policies Disrupt Our Ability to Assess Risk

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When central banks manipulate interest rates, they disrupt normal patterns of savings and investment. They pump up economic bubbles that ultimately pop and kick off economic crashes. We saw this vividly in the 2008 financial crisis. Low interest rates, along with government policies, encouraged unsustainable investment in housing. When the bubble popped, it nearly brought the entire economy down with it.

There is another problem with central bank interest rate tinkering that exacerbates bubbles.

It hides inherent risk.

When interests rates remain artificially low, it suppresses risk premiums and drives further malinvestement.

Thorsten Polleit writing for the Mises Institute Fed Watch explained the mechanism.

Inherent risk exists with any investment, but some are riskier than others. In an unfettered market, investors reap a reward in the form of higher yield for taking on higher risk.

For instance, a bond with a high default risk will typically carry a high yield. The same goes for debt denominated in an unsound currency. Stocks of companies that are deemed risky tend to trade at a lower valuation level than those considered low risk. All these risk premiums, if determined in the unhampered market, constitute a portion of an asset’s price, be it a bond or a share. They play a vital role in the way capital is allocated in an economy.”

When central banks push interest rates to artificially low levels, it interferes with normal market signals and makes it impossible to accurately assess risk.

Central banks interfere and corrupt the best practice of the formation of the price of risk. In the last financial and economic crisis, central banks had lowered interest rates to unprecedented low levels and ramped up the quantity of (base) money to keep financially ailing governments and banks afloat and the economy going. In fact, they effectively put out a ‘safety net’, providing insurance to financial markets against potential systemic losses.

“The yield spread of risky corporate bonds over US Treasuries has returned to levels last seen in early 2008. Or look at the prices for credit default insurance for bank bonds. They also have returned to pre-crisis levels, suggesting investor credit concerns have markedly declined. In other words, investors are back again, eagerly taking on additional credit risk and willingly financing corporates’ investments at suppressed costs of capital.

“Central banks have thus not only artificially reduced interest rates by lowering credit costs, they have also artificially reduced risk premiums by (explicitly or implicitly) signaling to the financial markets that they are prepared to basically ‘do whatever it takes’ to prevent another meltdown as witnessed in 2008/2009. The consequence is that financial markets and economies depend on central bank action more than ever before.

“By doing so, central banks have put investor risk aversion to sleep: Under their guidance, financial markets are now betting on, and have high confidence in, monetary policy makers successfully fending off any new problems in the economic and financial system. This seems to be the message the price action in financial markets is conveying to us. For instance, stock price fluctuations have returned to very low levels, accompanied by strong stock market gains and high valuations.”

As we have said in the past, the Federal Reserve has put itself between a rock and a hard place when it comes to interest rate normalization. It can try to normalize interest rates and risk popping the stock market bubble (among the other balloons) it has inflated over the last nine years. Or it can hold rates at the current artificially low rates and risk a currency crisis.

Polleit reiterated the squeeze the Fed finds itself in.

There is no easy way out of this situation. If interest rates go up — be it through rate hikes or the elimination of the ‘safety net’ — the current recovery will most likely come to a halt, if it does not turn into a bust straight away: With higher interest rates, the economic structure, built on artificially low interest rates, would run into serious trouble. The idea of central banks ‘normalizing’ interest rates without output losses or even a recession appears illusionary at best.”

 

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