Banks must find balance between continuing to support activity without sowing seeds of another asset bubble
The decade and a half after the tearing down of the Berlin Wall was a golden age for central banks. It was a time of strong growth and low inflation presided over by committees of technocrats charged with taking the politics out of the messy business of setting interest rates.
The European Central Bank (ECB) was created, the Bank of England was granted operational independence and Alan Greenspan ruled the US Federal Reserve.
Mervyn King, who retired last year after a 10-year stint in charge at Threadneedle Street, described the period from the mid-1990s to the mid-2000s as the Nice decade. That stood for non-inflationary continual expansion and in the west was primarily the result of cheap imports flooding in from China, which kept the cost of living low and enabled central bankers to hit their inflation targets while keeping borrowing costs down.
Times have changed. The six and a half years since the financial markets froze in August 2007 have been anything but nice. Greenspan is no longer called the Maestro – the title of a hagiography by Bob Woodward before the sky fell in – and is instead vilified as a serial bubble blower.
Central banks found that their traditional policy instruments were ineffective as the banks tottered in the autumn of 2008. They resorted to more potent weapons: dramatic cuts in interest rates, the creation of money through the process known as quantitative easing; inducements to persuade banks to lend; forward guidance on the expected path of interest rates to reassure individuals and companies that the cost of borrowing would stay low.
There was no 1930s-style slump and the global economy bottomed out around six months after the collapse of Lehman Brothers in September 2008. But recovery was slow by historical standards and the global economy has displayed signs of being addicted to the stimulants provided by central banks.
All of them will be under scrutiny in 2014 as the world's central bankers seek a way of getting the balance right in continuing to support activity without sowing the seeds of another asset bubble.
Get it right and the reputation of the Fed, the ECB, the Bank of England, the Bank of Japan (BoJ) and the People's Bank of China (PBoC) will be burnished. Get it wrong and the history books will look back on the crisis and its aftermath as the years when central banks lost the plot and saw their credibility shattered.
The Federal Reserve (US)
The Fed made its intentions clear last month when it announced it was scaling back its quantitative easing programme from $85bn a month to $75bn, with further tapering due to take place during 2014. At the same time, the US central bank softened its stance on interest rates and said unemployment will have to fall to 6.5% – and probably lower – before the cost of borrowing is raised.
The low level of inflation means that policy can remain stimulative under its new chairman, Janet Yellen, but with growth strengthening, the Fed has to beware repeating Greenspan's mistake in the early 2000s when he left rates too low for too long.
Dhaval Joshi of research house BCA said: "From January the Fed is going to reduce the pace of its asset purchases and shift the policy onus to its forward guidance on interest rates, relying on the credibility of its words and promises. As we are in uncharted territory, the eventual market reaction is unclear, and there is certainly the possibility of disruption."
The European Central Bank (ECB)
After a quiet 2013, the ECB has a number of big calls to make in the coming year. Not only is the recovery from a long double-dip recession tepid but the euro area as a whole is perilously close to deflation. Greece and Cyprus are already seeing the annual cost of living fall. So the first question for ECB president Mario Draghi is whether to seek to stimulate the euro area economy through quantitative easing – QE – just at the moment the Fed is tapering away its programme.
A second, linked issue is the strength of the euro, which threatens to choke off exports. David Owen of Jefferies says the ECB has two possible policy options: QE or co-ordinated intervention to weaken the currency. Markets will also pay close attention to the ECB's asset quality review of European banks, when it has to decide whether to come clean about the capital shortfalls many are believed to face.
If Draghi is too opaque he will be accused of a cover-up; equally, he will get the blame if a fully transparent approach leads to a run on banks and – because they are large holders of euro-area government debt – drives up sovereign bond yields.
The People's Bank of China(PBoC)
The challenge for the PBoC is simple: remove the credit excesses of the world's second biggest economy without causing a hard landing. November's third plenum of the Communist party in Beijing set the Chinese economy on a liberalisation course, a move welcomed by most analysts in the west as likely to ensure the long-term sustainability of growth.
In the short term, though, there is the little matter of easing growth back from the 10% per annum of recent years to 6.5% to 7%. On the plus side, China still has a battery of credit controls that will provide protection against mass capital flight if things start to get sticky; on the debit side, the vast quantity of credit pumped into the economy in 2008–09 has led to an overheated commercial property market, heavily indebted local government and industrial overcapacity.
An indication of the challenge facing the PBoC was provided by the spike in interbank rates to almost 10% last month – raising fears that a tightening of policy is causing a credit crunch for the banks.
The Bank of Japan (BoJ)
Japan is a warning to the ECB of what can happen if deflation is allowed to set in. Just over a year ago, Japan's prime minister, Shinzo Abe, announced a "three-arrow" strategy that became known as Abenomics: radical monetary easing from the BoJ, a Keynesian programme of public works, and structural reform.
In the early stages of the programme, the BoJ is doing the heavy lifting, using negative interest rates and quantitative easing to drive down the value of the yen, raise import prices and push inflation up towards its official target of 2%.
Japan is especially vulnerable to a slowdown in the global economy which, on past form, would attract speculative money into the yen, drive down prices and force the BoJ into even more unconventional measures.
The Bank of England (BoE)
Mark Carney's big innovation at Threadneedle Street has been forward guidance, which he used when governor of the Bank of Canada. This involves a commitment not to consider raising interest rates until unemployment falls to 7%, unless there is the risk either of inflation getting out of control or of a housing bubble that can't be tackled using measures specifically targeted on the property market. But the Bank has underestimated both the speed of the fall in the jobless rate and the pickup in the mortgage market. Carney's fear is that premature tightening of policy will kill off recovery in its early stages, but markets are starting to question whether he can hold the line until the next general election in May 2015.
