The limits of central banking 'toolkit'

The change in the Fed's forecast and a possible shift in policy is perhaps a good time to review how central banks - including the RBI - responded to the crisis, and debate future possibilities

Global financial markets are adjusting to the possibility of sooner than expected interest rate hikes by the US Federal Reserve. Although the Federal Open Market Committee (FOMC) — rate-setting body of the Fed — left the policy rate unchanged last week, its latest economic projections show interest rates can increase by 50 basis points by 2023. Some FOMC members expect to raise rates by next year. This is a big shift from the March meeting when most members expected interest rates to remain near-zero through 2023. The latest projections by the Fed are significant and would perhaps be seen as a turning point for the global monetary policy response to the pandemic. Monetary policy changes in the US tend to have global implications. For instance, the possibility of a reduction in asset purchase by the Fed in 2013 — known as the taper tantrum episode — led to significant capital outflow from emerging market economies, resulting in a near-currency crisis in India.

A similar crisis can be ruled out this time, but the change in the Fed’s forecast and a possible shift in policy is perhaps a good time to review how central banks — including the Reserve Bank of India (RBI) — responded to the crisis, and debate future possibilities. It is worth noting that the Fed’s economic projections changed materially over the past few months, which suggests that some uncertainty cannot be ruled out in the near-to-medium term. To be fair, Fed officials are responding to the rapidly changing macroeconomic environment. The headline consumer price inflation rate hit a 13-year high of 5 per cent in May. Although Fed Chairman Jerome Powell has maintained that higher inflation is transitory and will abate in the coming months, some economists believe the US central bank is behind the curve.

As a matter of fact, unlike last year when large central banks moved in a similar direction at the same time, unwinding of policy accommodation will happen slowly, and a large part of the stimulus might actually remain in the system permanently, which would have its own implications over time. A new edited book, Monetary Policy and Central Banking in the Covid Era, published by the Centre for Economic Policy Research and the International Center for Monetary and Banking Studies, offers some valuable insights as to how central banks responded to the Covid crisis, which was very different from a normal business cycle recession or a financial crisis. The first objective, certainly, was to stabilise the financial system and avoid economic dislocation. As the financial system stabilised, thanks to massive liquidity infusion, central banks started focusing on growth and inflation. Emerging market central banks acted cautiously in the initial phase because of market volatility and capital outflows. But things changed as markets stabilised. Central banks quickly restored to tools used during the global financial crisis and added more to their toolkit.

In advanced economies, central banks reduced rates to near zero along with massive asset purchases. The government bond holdings of the Bank of England and Bank of Canada, for instance, have gone over 40 per cent of the total outstanding. The US Fed also rapidly expanded its balance sheet and is still buying bonds worth $120 billion per month. Its balance sheet size has nearly doubled since the outbreak of the pandemic to about $8 trillion. Some of the central banks, including the Fed, Bank of England, and the European Central Bank, also directly supported the private sector and bought corporate bonds and commercial papers. The People’s Bank of China supported lending to over 7,000 private entities. Besides, regulatory relief was extended to the banking system, and central banks used forward guidance effectively to assure financial markets. Furthermore, somewhat contrary to their conventional position, central banks actively supported large fiscal intervention.

The RBI also reduced policy rates and flooded the system with liquidity. In addition, it conducted targeted long-term repo operations to ease liquidity conditions in various sectors. The Indian central bank, however, did well to not directly buy corporate paper as was suggested by several commentators. It is also actively supporting the government borrowing programme — which has expanded significantly— by not allowing interest rates to move up. The RBI in its latest monthly bulletin, for example, noted: “...the RBI engaged in large scale open market purchases of government bonds in the secondary market, effectively taking the overload of pandemic-related security issuances by the government on to its balance sheet.” But it remains to be seen till when the RBI will tightly control the yield curve, given the persistent inflationary pressures.

In fact, unwinding monetary accommodation would be a challenge for most central banks. Policy rates for large central banks are near zero. Some already had interest rates in the negative territory even before the start of the Covid crisis. Further, central bank balance sheets have expanded enormously and a large part of it may never be reversed. In this context, there are a number of policy issues that need to be debated. For instance, in case of another crisis in the medium term, would central banks have the tools to address the situation? Would continuous excess money infusion not create moral hazard and encourage excessive risk-taking? Will rapidly rising asset prices keep increasing inequality? With very large balance sheets, would central banks themselves be reluctant to raise interest rates to avoid losses, which can have fiscal implications and potentially affect their independence. Finally, will the continuous money creation eventually result in sustained excess inflation or hyperinflation? Some of these issues would dominate policy discourse and, of course, financial market trades in the coming months.