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There is a story in Mahabharat about Arjun’s son Abhimanyu: he had learnt how to penetrate the enemy’s defence system, the Chakravyuha, but not how to get out. In the process, having successfully penetrated the Chakravyuha, he was killed. One wonders whether central banks in advanced industrial economies – the US, the euro zone and Japan – are today facing Abhimanyu’s dilemma. Ever since the 2008 financial crisis, they have been easing money supply, lowering interest rates to near-zero levels, and bloating their balance sheets to unprecedented sizes, indeed in trillions of dollars. Since yields cannot drop further, surely the 30-year uptrend in bond prices has to reverse at some point of time.
To be sure, there are some differences in the three major economies: in the US, growth has resumed, if only haltingly, and the number of those seeking jobs has fallen in recent months. This has strengthened expectations that dollar interest rates would start rising later this year. In the euro zone, the economy still faces the spectre of deflation, and the prospects are further clouded by the possibility of a Greek default and/or Grexit from the single currency. In the euro market alone something like $3 trillion of bonds now have negative yields and major banks have recently announced negative interest rates for deposits in the euro and a few other European currencies. In Japan, both monetary and fiscal stimuli have failed to lead to a definite trend in inflation or growth. Recently, inflation has been positive, but more because of a rise in sales tax from 5% to 8%: it is anybody’s guess what happens when that effect gets absorbed. Will Japan once again experience negative inflation?
To my mind, these variations between the three major economies emphasise the importance of demographics to inflation and growth. In the US, the problem of an aging population is mitigated by immigration; not so in the euro zone or Japan. This relevance of demographics is also seen in the world’s largest economy (in purchasing power parity terms), China; the impact of its 60-year old “one-child” policy means a relatively stagnant working age population now. (To be sure, growth is falling partly also because a “great rebalancing” of output from exports to domestic consumption.) All the empirical evidence suggests the need to incorporate the effect of demographics in macroeconomic models. Most central banks continue to believe in the good old dynamic, stochastic general equilibrium (DSGE) model for policy decisions. The model ignores not only demographics, but also the financial sector!
The big issue is what happens if and when the interest rate cycle changes direction. How much turmoil will it cause in financial markets of the three major economies? What kind of losses could investors in bond markets suffer? What will be the impact on portfolio investment flows to the developing/emerging markets? Or on exchange rates? As for the first two questions, no dramatic change may happen in Japan, which has been living with near zero interest rates for a couple of decades; in fact, last week, the IMF advised Japan to increase monetary easing.
As for the US and Europe, one wonders whether the events of the last few weeks are but a trailer of the main picture. Even as the European Central Bank announced larger purchases of bonds in May and June, the yield on the 10 year “Bund” (German government bond) went up from an all-time low of 0.08% in April to 0.6% in a few weeks, leading to a loss of $500 bn for global bond market investors! Alan Greenspan, the former Chairman of the Federal Reserve, believes that the process of normalising interest rates “is going to be very rocky”.
In Europe, there are problems on both the supply and demand sides. As for the former, the net supply of government paper (new issues less maturities) barely equals the ECB’s planned purchases. On the demand side, how many buyers will be comfortable locking into current yields for the long term? To be sure, some major investors will be forced to buy the bonds irrespective of yields for regulatory compulsions: for example, life insurance companies. Their problems are compounded because surely nobody factored in today’s yields while fixing policy premia 20 years back!
One possibility is that the advanced economies are now entering into an era of “great stagnation” in both growth and inflation. And that may imply that today’s bond yields are the new norm. So turmoil or stagnation? Toss a coin?
