Mark Carney warns of liquidity storm as global currency system turns upside down
Governor tells audience at Davos that monetary tightening from the Federal Reserve will "test the resilience of the financial system"
By Ambrose Evans-Pritchard, and Szu Ping Chan, in Davos
5:50PM GMT 24 Jan 2015
Divergences in monetary policy could bring a new wave of global instability, warned Mr Carney Photo: Reuters
The Governor of the Bank of England has warned markets to brace for possible trouble in 2015 as the US Federal Reserve tightens monetary policy and liquidity evaporates, fearing that the new financial order has yet to face its first real test.
Mark Carney said diverging monetary policies in the US, Britain, Europe, and Japan may set off further currency turbulence and "test capital flows across the global economy, including to emerging markets."
It is the latest sign that officials at Threadneedle Street are worried about the global fall-out from the rising dollar, which poses a mounting threat to companies in the developing world that have borrowed up to $9 trillion in US dollars.
Mr Carney said regulators have cleaned up the banks and tried to prepare for the tectonic shift taking place in the international currency structure but major risks remain.
"This will test the resilience of that new financial system. It has a potential feedback and we have to be aware of that," he told an elite group of central bankers at the World Economic Forum.
"We are particularly concerned about an illusion of liquidity that has existed in a number of financial markets. I would say that illusion of liquidity is gradually being disabused," he said, adding that the so-called 'flash crash' in the US Treasury market last October was a wake-up call even if the "bouts of losses" have been small so far.
Mr Carney said the global authorities have clamped down on excess leverage and the sort of behaviour by banks that caused the financial crisis seven years ago, but new worries have emerged.
"The big question for us now is about liquidity cycles that come from fund managers that don't have leverage. It's $35 trillion of mutual funds that invest in relatively illiquid securities," he said.
Global watchdogs say the scale is so large -- and subject to "clustering" and crowd psychology - that these funds may all rush for the exits at the same time in a crisis and amplify the effects.
The concerns were echoed by Benoît Cœuré, a board member of the European Central Bank.
"The system is untested. We had a wave of new financial regulation, which has mostly focussed on banks, so we're pretty sure that banks are much safer," he said.
Mr Cœuré said the ECB was forced to throw caution to the winds and launch a €60bn blitz of bond purchases on Thursday, given that inflation expectations in the eurozone have collapsed, with outright deflation in December.
"It was pretty clear we had to do something. The only discussion was how to do it," he said.
"Being patient is a risk that we just don't want to take. We need growth in Europe. With entrenched unemployment, people are being forced out of the labour market, and we are seeing the whole foundation of the European project being weakened. This cannot last for too long," he said.
Mr Cœuré warned that no central bank can work magic and that the real burden lies with fiscal policy and structural reform. "There is nothing we can do at the ECB to lift growth in a lasting way. We did our part, governments have to do their part," he said.
Mr Carney defended quantitative easing against those who argue that it leads to asset bubbles and leads to rising inequality without doing much to boost the real economy. "All monetary policy has distributional consequences. We lower interest rates and it benefits debtors at the expense of people who've saved money, and I can assure you I hear from savers and I understand that," he said.
Yet the moral imperative of battling high unemployment is greater. "When people are unemployed for too long, they lose their skills, so called hysteresis. There has been a race against hysteresis. In the UK, we created over 600,000 jobs in the last year. Wages are starting to pick up, and we're winning that race," he said.
The Governor vowed to bring inflation back to its 2pc target after it dropped to 0.5pc in December, and may soon go negative by some estimates. "We have a very low inflation environment right now, largely caused by commodity prices," he said.
Mr Carney said the Bank will "look through" the latest dip but do whatever it takes meet its mandate over the next two years. "We have the means, and the will, and the responsibility to do it, and we will do it. People can rely on that," he said.
"We are particularly concerned about an illusion of liquidity that has existed in a number of financial markets. I would say that illusion of liquidity is gradually being disabused," he said, adding that the so-called 'flash crash' in the US Treasury market last October was a wake-up call even if the "bouts of losses" have been small so far.
Mr Carney said the global authorities have clamped down on excess leverage and the sort of behaviour by banks that caused the financial crisis seven years ago, but new worries have emerged.
"The big question for us now is about liquidity cycles that come from fund managers that don't have leverage. It's $35 trillion of mutual funds that invest in relatively illiquid securities," he said.
Global watchdogs say the scale is so large -- and subject to "clustering" and crowd psychology - that these funds may all rush for the exits at the same time in a crisis and amplify the effects.
The concerns were echoed by Benoît Cœuré, a board member of the European Central Bank.
"The system is untested. We had a wave of new financial regulation, which has mostly focussed on banks, so we're pretty sure that banks are much safer," he said.
Mr Cœuré said the ECB was forced to throw caution to the winds and launch a €60bn blitz of bond purchases on Thursday, given that inflation expectations in the eurozone have collapsed, with outright deflation in December.
"It was pretty clear we had to do something. The only discussion was how to do it," he said.
"Being patient is a risk that we just don't want to take. We need growth in Europe. With entrenched unemployment, people are being forced out of the labour market, and we are seeing the whole foundation of the European project being weakened. This cannot last for too long," he said.
Mr Cœuré warned that no central bank can work magic and that the real burden lies with fiscal policy and structural reform. "There is nothing we can do at the ECB to lift growth in a lasting way. We did our part, governments have to do their part," he said.
Mr Carney defended quantitative easing against those who argue that it leads to asset bubbles and leads to rising inequality without doing much to boost the real economy. "All monetary policy has distributional consequences. We lower interest rates and it benefits debtors at the expense of people who've saved money, and I can assure you I hear from savers and I understand that," he said.
Yet the moral imperative of battling high unemployment is greater. "When people are unemployed for too long, they lose their skills, so called hysteresis. There has been a race against hysteresis. In the UK, we created over 600,000 jobs in the last year. Wages are starting to pick up, and we're winning that race," he said.
The Governor vowed to bring inflation back to its 2pc target after it dropped to 0.5pc in December, and may soon go negative by some estimates. "We have a very low inflation environment right now, largely caused by commodity prices," he said.
Mr Carney said the Bank will "look through" the latest dip but do whatever it takes meet its mandate over the next two years. "We have the means, and the will, and the responsibility to do it, and we will do it. People can rely on that," he said.
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