Central banks facing a new equilibrium

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Central bankers around the world are pondering the future of their massive bond buying programs in a post-pandemic world, knowing that with big balance sheets come big expectations.

The developed economies of the Group of Seven racked up an estimated $ 7 trillion in debt last year as they spent heavily to fight the pandemic and support their economies. Central banks ended up owning much of this new debt, according to Bloomberg Economics.

Featured in the June / July issue of Bloomberg Markets.

Illustrator: Rachell Sumpter

Even as asset purchases continue, with hundreds of billions of dollars spent each month, officials at the U.S. Federal Reserve and the European Central Bank are among those determining how – or if – they can reduce battery stacks. assets that have been a mainstay of financial markets for over a decade.

The problem is, markets have come to expect central banks to use their purchasing power to iron out any suspicion of a problem. Governments may be tempted to rely on monetary authorities to use it to keep borrowing costs low indefinitely. And activists are now also calling on monetary officials to use their firepower to tackle inequality and even climate change. These disparate expectations add to the unease fueled by economists who have for years warned of the long-term effects of quantitative easing.

“The Fed’s record is going to be gigantic for a long time,” says Alan Blinder, a former Fed vice chairman who is now a professor at Princeton. “This worries some people,” he says, but not Blinder himself.

Investors have already sounded the alarm bells. A rout in government bonds rocked markets earlier this year.

QUANTITATIVE FACILITATION TOOLS have been a welcome boon for monetary institutions faced with policy rates already close to or below zero. But they also amplified the political profile of central banks, leaving them more prone to entanglement in fiscal policy – or perception than they could be.

So-called fiscal dominance – in which central banks are prevented from acting on their inflation mandates for fear of harming government finances – is the problem. It is associated with a range of concerns, ranging from the erosion of independence, with the possibility of policymakers keeping policy too loose and triggering inflation, to regime change in which government borrowing is monetized, central banks buying debt directly or agreeing to buy a certain amount.

The road traveled is clearly visible in Europe. While once the simple purchase of euro-zone country debt in secondary markets sparked accusations of illegal monetary financing, senior politicians in Italy and France have in recent months demanded that the bonds listed in the European Central Bank’s balance sheet be canceled or turned into “perpetual” bonds that are never redeemed.

The idea that the public debt must be honored is called into question. “We are moving towards this kind of modern monetary theory scheme where debt and free money are supposedly of no consequence,” says Charles Plosser, former chairman of the Federal Reserve Bank of Philadelphia, who is now a member of the Hoover Institution. “What worries me at the end of the day is the politicization of the central bank.”

The concern relates to a specific set of circumstances: With such a large balance sheet, a central bank such as the Bank of Japan, the Fed, or the ECB is the government’s chief buyer. Indirectly, the monetary authority controls the cost of government borrowing. The current debates over what is known as yield curve control – that is, buying that targets a specific return at a given grade – only underscores this fact.

But if inflation does occur, the central bank governor is in deep trouble. Raise the rates, and the government is screaming. Keep them low and you will prove that your independence and credibility to fight inflation is gone.

The simple way out of this dilemma is to reduce the size of debt holdings as quickly as possible. Bank of England Governor Andrew Bailey hinted last year that he could favor an aggressive contraction also because it could create more leeway in the event of a future emergency.

But in 2013, after the United States emerged from the crisis triggered by the subprime meltdown, the Fed signaled an attempt to “shrink” its own balance sheet, causing bond yields to rise immediately and market turmoil. global. Central bankers are reluctant to do the same thing again. Fed officials say there is no need to discuss a change in the pace of bond purchases until much greater progress is made on their employment and employment goals. inflation. Investors are focused on when that moment might come.

The lesson from the Bank of Japan, which has moved further in the direction of fiscal dominance than its peers, seems to be that any attempt to reduce debt holdings today could take a generation or more. “The BOJ will have to do this very, very slowly, hoping no one notices,” said Richard Koo, chief economist at the Nomura Research Institute in Tokyo and former adviser to Japanese prime ministers. “If they do it very carefully over, say, 20 to 30 years, maybe they can bring the balance sheet back to something normal.”

Quantitative Easing has been part of the monetary toolbox for so long that the definition of “normal” has changed. While once the Fed maintains a “meager” balance sheet just above the value of the banknotes issued, there is little chance of a return to that. There are a variety of reasons central bankers will want to hold on to at least some of their current holdings indefinitely, ranging from preserving their ability to intervene and helping the market to function properly to assisting in the conduct of monetary policy.

To do this, central bankers may need to prove that they are not being picked up by their finance ministries and that, when inflation returns, they can react. Vitor Constancio, ECB vice president until 2018, says fears about fiscal dominance are “wishful thinking” on the part of market investors, a narrative that prompts the central bank to maintain loose policy indefinitely.

“When inflation normalizes consistently, central banks will start to shrink the size of their balance sheets,” Constancio said. “I have no doubt about it.”

Black is a writer for Europe Finance at Bloomberg News in Zurich.

– With the help of Toru Fujioka, Rich Miller and Enda Curran

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