You thought central bank money printing was at an end? Don’t bet on it

Is the great bond market bubble finally over? For the following, very simple, reason, I’m not yet convinced.

The world economy is still in a very deep hole, with major structural imbalances still largely unaddressed. Any attempt to apply the brakes would only choke off what remains a very fragile and unconvincing recovery, tipping some major economies back into recession.

This in turn means that central banks will struggle to remove monetary accommodation in the way markets are starting to anticipate. We’ve become hooked on easy money, and I very much doubt the world economy is yet ready for the cold turkey of its withdrawal.

As if to prove the point, there were two absolute shockers in the data from the world’s two leading economies on Monday. Both the US and China saw a contraction in manufacturing activity in May. But worry not. In the “through the looking glass” world occupied by financial markets, what for the real economy looks like unadulterated bad news can, in fact, be seen as good news, for it may mean that central banks are forced into another burst of money printing after all.

This, however, is not the prevailing narrative in markets right now, where – encouraged by a recent run of mainly positive economic news and loud noises by a number of Federal Reserve policymakers – there is now widespread anticipation of tighter money to come.

I’ve been more positive than most over the past six months on the outlook for both the UK and wider global economy, so now that a few rays of sunshine seem to be breaking through the clouds, I’m not about to dismiss as off-the-wall nonsense expectations of more normalised conditions to come.

All the same, markets do seem to be getting somewhat ahead of themselves in thinking the return of tighter money is just around the corner. This continues to look highly unlikely, though some at the Federal Reserve are plainly going to take some convincing.

On Monday, John Williams, president of the San Francisco Federal Reserve Bank, repeated his view that an improving US economy would allow the Federal Reserve to slow its programme of bond buying over the summer and stop it altogether by the end of the year.

With a number of other Federal Reserve policymakers saying much the same thing, it is small wonder that markets have started to believe it. Minutes to the last meeting of the Federal Reserve’s Open Markets Committee pointed unambiguously to a tapering off in asset purchases, or “quantitative easing”.

Nor is it surprising that John Williams, in particular, should hold such a view. From San Francisco, the world again feels like a pretty dynamic place. The tech boom is back in full swing and house prices are once again going through the roof. Essentially bankrupt just a few years ago, California as a whole has returned to budget surplus, which means that at a state level at least, government spending cuts can start to be reversed.

For California, the economic crisis is already just a memory. Likewise in New York, where restaurants and stores are filled to capacity.

It would be silly to extrapolate from these temples of innovation and consumerism, yet throughout the US, that there are now unmistakable signs of life. Banks are back in expansionist mode and all 20 cities covered by the Case-Shiller Index have posted year on year gains for house prices in January, February and March. The composite index was up 10.9pc year on year in March. To some, it looks as if the US has achieved the “escape velocity” necessary to start withdrawing monetary support. Even Eric Rosengren, the previously ultra-“dovish” president of the Boston Fed, has said that QE may need to slow.

We’ve been here before. Since the crisis began, there have been several apparent economic springs, prompting the Fed to cease asset purchases, only to be forced back to the printing press again when the economy flagged. What may be different this time is that central bankers as a breed are losing their nerve in the pursuit of unconventional monetary policy. Some now openly question its effectiveness in stimulating the real economy. Others worry about its distributional consequences, with debtors favoured at the expense of savers. Still others worry about the re-emergence, in the hunt for yield, of asset price bubbles. They also worry about loss of independence, with QE now quite widely seen as a form of government financing. In almost all cases, there is growing concern about the sheer scale of balance sheet expansion.

Are these worries well founded? Most certainly. But are they enough to justify a return to a more normal interest rate environment? Not as long as deflation and a weak economy remain the primary risks for many advanced economies.

Central banks seem caught on a treadmill of money printing, where even the merest hint of exit threatens another financial crisis. This, in turn, would require a further dose of money printing to blow away the consequent economic fallout. There’s no escape.

Since QE began, there have been repeated warnings from monetary traditionalists of an inflationary death spiral, yet, though interfering with such a vitally important market price as sovereign bonds has undoubtedly had many negative consequences, this has not been one of them.

Even in the UK, underlying inflation, after stripping out the effects of tax rises and the impact on prices of currency devaluation, has been pretty subdued, while in parts of the eurozone there is outright price deflation, apparently deliberately pursued as a way of force-marching the periphery back to competitiveness with the German core.

It’s a very strange central bank that pursues a deflationary policy goal but then the madness of the single currency seems to require such bizarrely back to front thinking.

For the rest, there is a purpose in all this money printing that dares not speak its name. If nominal GDP is rising, it should, all other things being equal, steadily reduce the debt burden.

The negative real interest rates that QE has induced – sometimes called “financial repression” – have not only helped governments finance themselves at much lower rates than otherwise but they are also eroding the real value of government debt.

For highly indebted nations such as the UK and the US, this is generally regarded as more politically palatable than the alternatives – defaulting or truly punishing levels of austerity. It’s also one of the primary reasons for Abenomics in Japan. Unless Japan can get some inflation back into the economy, the state will eventually go bust.

The rise we have witnessed in sovereign bond yields so far is certainly notable but it was from an extraordinarily low base. Yields are still negligible by historic standards. Keeping them there depends on more money printing.

I’m guessing that, with financial markets threatening their customary havoc if they don’t get it, this is indeed what we will see.