The economists from the BIS published this summer another interesting working paper, titled “Monetary policy, the financial cycle and ultra-low interest rates”. What can we learn from it?
In the world of vulgar economics, the Bank of International Settlements appears as a bastion of reason. You see, almost all central bankers and academic economists are now chatting about a decline in the natural rate of interest. For example, Brainard in her speech stated that the neutral interest rate is likely to remain very low for some time, as we reported yesterday. What always struck us was the naïve and simplistic belief that the observed decline in real interest rates is purely a function of forces beyond the central bank’s control. The central bankers seem to say: “Agree, we slashed interest rates and ballooned the central banks’ balance sheets, but, hey, it could not affect real interest rates. Nah, what a silly idea! It’s not us, it’s them! We are just innocent technocrats who merely passively track the natural rate in a heroic struggle with the dark and external forces”.
Now, Claudio Borio and his team demolish this approach. Let’s quote the abstract from their paper:
“Do the prevailing unusually and persistently low real interest rates reflect a decline in the natural rate of interest as commonly thought? We argue that this is only part of the story. The critical role of financial factors in influencing medium-term economic fluctuations must also be taken into account. Doing so for the United States yields estimates of the natural rate that are higher and, at least since 2000, decline by less. As a result, policy rates have been persistently and systematically below this measure. Moreover, we find that monetary policy, through the financial cycle, has a long-lasting impact on output and, by implication, on real interest rates. Therefore, a narrative that attributes the decline in real rates primarily to an exogenous fall in the natural rate is incomplete.”
The implications for the gold market should be clear. Mainstream economists neglect the impact of monetary policy and financial factors and, thus, overestimate the decline in the natural rate. In consequence, they conduct an excessively expansionary monetary policy and keep the interest rates too low for too long. Similarly, Borio said yesterday during a conference in Vienna that central banks should take financial stability into account rather than focus exclusively on price stability, learning to live with inflation rates that persistently miss their targets rather than fuel debt with increasingly aggressive stimulus policies. The current flawed monetary policy will not have a happy ending, as it encourages the build-up of serious financial instabilities. Therefore, investors should remember that the next crisis will strike one day. Gold should shine then. It goes without saying that this applies to the long term – this week, the uncertainty over the BoJ and the Fed meetings seems to be the one of the most important factors in the gold market.