Central bank independence? Don't make us laugh

published 3 October 2007

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It's almost funny how quickly central bankers can change their tunes.

Up until now, the main refrain from the Federal Reserve - and central banks across the world in general - is that you can't and shouldn't try to control asset prices. All through the long housing booms on both sides of the Atlantic, the focus has always been on tame consumer price inflation.

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But it's strange how all that hard-debated academic knowledge goes out of the window as soon as a recession threatens. Now that house prices are falling in the US, some Fed members are suddenly calling for rate cuts based on the very property prices that were irrelevant when they were rising.

And now that real problems are looming, the politicians are eager to put the squeeze on the Bank of England too

When property prices were booming, rocketing values were downplayed in the US, while in the UK, despite clear signs of discomfort on Bank of England governor Mervyn King's behalf, house prices were widely ignored when it came to setting policy.

Yet, now that prices in the US are falling, they have suddenly become far more relevant. One of the Fed governors, Frederic Mishkin has now said that it's a good idea for policymakers to "react immediately to a house price decline when they see it." Meanwhile, in the UK, The Telegraph reports that the Treasury Select Committee is to "grill" Mervyn King and his deputy Sir John Gieve over their handling of the current liquidity crisis.

The Bank of England has been under increasing pressure to follow peers like the Fed and the European Central Bank in pumping liquidity into money markets. The rift between many in the City and the Bank has been emphasised by the weekend whining from Barclays Capital's Bob "don't call this a rescue - it's a restructuring" Diamond. Mr Diamond - the country's top-paid executive last year - effectively called for the Bank to act to unfreeze the crucial three-month lending market.

Now it looks like the pressure is coming from the very top. Michael Fallon, the top Conservative on the Treasury Select Committee, told the paper: "The Bank is handling this very differently from other central banks. We need to understand why."

We suspect that the Bank has a far better understanding of what it's doing than anyone on the Select Committee. We also suspect that what the politicians want is a silver bullet to ensure that growth never dips, house prices rise forever, and the electorate never stops spending. They are unlikely to rest until the Bank says it will slash interest rates and make everything better again.

But here's the problem. If you're going to ignore rampant credit growth and asset price bubbles on the way up, then you have to live with the consequences of that on the way down. You can't separate the two. The apparent abundance of money lead to investors from banks to hedge funds making bad investments and taking stupid risks - as it always has. A sudden realisation of just how bad those investments were has lead to a sudden drying up of that once-abundant money - as it always does. And the fall-out will be painful, regardless of what central banks do now - as it always is.

This is what's known as a Minsky moment (for a full explanation, read: /file/27889/have-we-reached-a-minsky-moment). And once investor sentiment has turned, it takes far more than a couple of interest rate cuts to turn it back around.

The Bank knew this a long time ago. It's been warning on both house prices and credit derivatives for a long time. As recently as June, Mervyn King warned the City to be "cautious about how much you borrow."

"It may say champagne - AAA - on the label of an increasing number of structured credit investments. But by the time investors get to what's left in the bottle, it could taste rather flat."

Barclays and chums laughed off the warning. The music was still playing, so they just kept on dancing. Now they're feeling the hangover kicking in, they shouldn't expect the Bank to shell out for another round of partying.

Turning to the wider markets

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London's FTSE 100 index closed with moderate gains yesterday, up 11 points to 6,315. Barclays headed the blue-chip risers along with fellow banks HBOS, Standard Chartered and Royal Bank of Scotland. For a full market report, see: London market close.

Elsewhere in Europe, the Paris CAC-40 was down 11 points at 5,651. Shares in both Suez and Gaz de France were both lower following news of a long-awaited merger agreement. In Frankfurt, the DAX-30 was up 10 points to 7,648.

Across the Atlantic, Wall Street was closed for the Labor Day holiday yesterday.

In Asia, traders were cautious ahead of a week of key economic data and interest rate decisions in the US and Europe. The Japanese Nikkei lost 104 points to close at 16,420. And in Hong Kong, the Hang Seng was down by as much as 18 points to 23,886.

Crude oil had risen to $74.28 this morning and Brent spot was at $73.99.

Spot gold was up to $673.20 from $671.80 in London late yesterday. And silver had edged up to $12.12.

In the forex markets, the pound had fallen to 2.0141 against the dollar and 232.45 against the yen, but was flat against the euro at 1.4814.

And in London this morning, life insurer Standard Life announced a 71% rise in first-half operating profit. Profit - calculated under the European Embedded Value rules, including investment assumptions - was up to £353m from £206m, thanks to UK pension gains. Shares in Standard Life had risen by as much as 0.9% in early trading.

And our recommended articles for today...

Why now is the time to rent, not own

- All over the country, buyers who stretched themselves to get on the property ladder in the belief that house prices only ever go up are finding that that's not necessarily the case. As the housing market demonstrates clear signs of stress, Merryn Somerset Webb reveals why she's chosen to sell-to-rent: Why now is the time to rent, not own

Could we be in for an interest rate cut this week?

- There are two very good reasons why the Bank of England will be feeling far less hawkish now than it did this time last month. But those City pundits predicting cuts should be wary of getting carried away, says Brian Durrant. Click here to find out more about the factors that will be influencing the MPC's decision on Thursday: Could we be in for an interest rate cut this week?

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.