The FINANCIAL -- In order to combat the financial and euro debt crisis, major central banks have not only pushed key rates down to record lows close to zero, but have also deployed a number of new instruments, according to Allianz.
“Low money and capital market rates, combined with an abundance of liquidity in the international financial system, are bolstering the economic recovery. At the same time, however, relatively safe investments are becoming less attractive,” said Michael Heise, Chief Economist at Allianz SE.
According to Heise, this is to a certain extent a welcome development: investors are given an incentive to shift their funds to riskier investments that hold the promise of higher returns, which generally helps to promote more favorable financing conditions. The "hunt for returns" can, however, also bring about adverse developments: if risk is disguised or inadequately measured, it can end up being concentrated in various areas of the economy and financial system unexpectedly.
“The low interest rate environment then threatens to become a breeding ground for future financial imbalances. When deciding whether to continue with the unusually expansive monetary policy over a more prolonged period of time, the benefits and the risks need to be weighed up carefully,” Heise added.
The crisis policy pursued by the major central banks is the subject of much controversy in the public arena. On the one hand, central banks are being showered with praise for having used their role as key players to prevent the crisis from escalating even further. On the other, critics warn of the long-term risk of inflation. In the euro area, the ECB is also being accused of state financing through the back door with its bond-purchasing (OMT) program, which is also removing the necessary pressure on crisis countries to reform. To keep things in perspective, however, it is important to note that the countries in crisis have made considerable progress with their reform and adjustment efforts, even if the timelines for consolidation have been stretched due to the economic conditions.
“In the long run low interest rates pose a problem to savers looking to accumulate assets and negative real interest rates can distort investment decisions and potentially feed financial market bubbles,” Heise added.
Excesses on the financial markets are a key argument in favor of an exit from monetary policy crisis mode. The longer the central banks wait, the more hooked the markets will become on the monetary policy medicine and the more extreme the reactions will be if the withdrawal treatment is not administered gently enough. The spike in yields in the summer months sparked by hints that the Fed would be retreating somewhat from its extremely loose monetary policy provided a taste of things to come in this respect.
At the beginning of the year eurozone inflation fell to 0.7%. That fueled the debate whether the European Central Bank should agree on further expansionary measures. That would not be advisable, according to Allianz.
Although inflation is currently below the ECB’s reference value of close to 2%, this deviation is not critical. The current inflation rate is being pushed down by lower energy prices, a positive but probably temporary feature. More importantly, in a number of countries falling unit labor costs are keeping price levels stable or, as in Greece, actually pushing them down. This is not only desirable but also vital in order to bolster competitiveness in these countries.
Initial successes are already evident: economic sentiment is improving in those countries with major adjustment needs. For the first time in a long while capacity utilization in the eurozone has risen and lending terms for small and medium-sized companies are no longer being tightened but relaxed. Stable inflation is not prompting consumers to sit on their wallets, rather we are seeing a fall in saving rates in most countries. “Further rate cuts are certainly not called for, but further liquidity assistance, yes,” stressed Heise.