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The central bank’s trap

Jean-Pierre Dumas

November 22, 2021

Mr Sharma raises in the FT an interesting question but gives, in my view, an unsatisfactory response. “Though inflation is making a strong comeback, why are rates now rising only for shorter-term bonds?” this is a question we share without any clear answer.

· The market will not accept higher interest rates

His answer is the market will not allow interest rates to move higher because the world is far too indebted (public and private debt). In effect, if rates rise from their low level, then there will be a financial panic. This is not acceptable either for the financial world or for main street actors (this is not because it is not acceptable that it will not occur); therefore the market will refuse long-term rates to rise significantly. Perhaps this is to take one’s desire for reality.

I am not a finance specialist, nor a market insider, but according to basic economic theory, generally long-term bond rate increases at least with expected inflation (so you are going to say, economists consider that facts are wrong since they do not fit economic theory). Perhaps the market believes, as most central bankers, particularly Madame Lagarde, that inflation is nothing else than an evanescent phenomenon; tomorrow (next year) inflation will come back to its target. Perhaps the market (which does not know better) is simply hypnotize by a new situation which is not normal (in this case this is a very unstable equilibrium, markets are quickly changing mood).

Mr Blanchard tells us that interest rates (r) are declining since the 14th century… and will likely stay at their very low level; therefore, r will be below the rate of growth (g) and the debt ratio is no more an issue (O. Blanchard only “forgets” the primary deficit ratio in the debt dynamic equation, and the primary deficit ratio is likely to be higher than r-g then the debt ratio will continue to increase whatever the “low” interest rate)

. It is unlikely that primary deficits will be lower than r-g.

Primary deficits are and will continue to be the rule rather than the exception (the various US fiscal stimulus, the Southern European countries’ addiction to fiscal deficit encouraged by all economists preaching for always more deficit to finance big green “investments” (see inter alia M. Sandbu, the FT economist) can only lead to higher public debt ratios.

. Interest rates include not only inflation expectations but also a risk premium

It is true that today the risk premium is nil, this is due to the suppression of bond vigilantes by the QE policy (see the pertinent analysis of R. Ramaswamy in the IMF F&D (2018). Let’s assume, for one second, that QE does not exist, do you really think that 10-year gov’t bonds can reach 1.2% for Greece, 1% for Italy, 0.1% for France, without forceful QE by the ECB? The interest rate is distorted by CB’s QE policy.

In an interesting conference (EconPol), D. Gros flags the importance of risk premium on the debt service burden. The debt service burden of a country = interest payments + amortization of past debt.

Interest payments = (risk-free interest rate)*(debt) + (risk aversion)*(debt2)

Therefore, the debt service burden, according to D. Gros, is a function of risk premium which may increase exponentially with risk aversion.

Major CBs are in a trap they are obliged to continue QE to cancel the risk aversion component of the interest payment. The Fed is planning to reduce the pace of its QE by $15 bn a month, it is correct that this announcement did not provoke any major disruption of market interest rate (this is Mr Sharma’s point) but this is not the end of the story. Why Madame Lagarde and the ECB’s board (without Mr J Weidmann) insist so much that it is not necessary to tighten. It is likely that any stop of the ECB’s QE will be followed by an adjustment of the interest rate for the fragile countries with actual interest rates not consistent with market forces and then the risk aversion component of interest rates will not be nil anymore but will apply to the square of the debt. “Marginal cost of higher risk aversion increases with square of debt ratio” D. Gros.

So, according to R. Sharma, the financial world, realizing that private and public debts have reached such an unsustainable level, considers that the market will not allow any rate increases, because any significant rise is just not sustainable. This seems to be a version of “too big to fail”, We, the authorities, will not allow a bank to fail because it is too big. Instead of the market, we must replace the word “market” by CBs, We, the big CBs will not allow the market to disrupt the ultra-low interest rates because this will entail a financial crisis. CBs are in a contradictory situation: either they will continue an expanding monetary policy to maintain interest rates at their low levels to the risk of inflation, or they will start a monetary retrenchment (QE slowdown with progressive interest rate increase) with the risk of the risk interest rate overshooting.

For D. Gros debt can spiral out of control even with constant primary surplus. “The cost of public debt is not function of today ratio it is likely to increase more than proportionally with debt ratio” D. Gros. “Never compare a multiplicative, systemic and fat-tailed risk to a non-multiplicative, idiosyncratic, and thin-tailed one”. N. Nicholas Taleb, “Skin in The Game”

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