The demands on global monetary policy and the role of central banks have changed quite dramatically since the onset of the financial crisis in 2008. Central banks have gone beyond their main remit of ensuring price stability to supporting the banking sector and relieving sovereign debt problems. The most recent example is the European Central Bank’s two long-term refinancing operations (LTROs) that attempted to reduce the risks of a European banking crisis and bolster demand for European sovereign paper. The Federal Reserve, too, played a critical role in improving financing conditions in 2009 and 2010 via its two quantitative easing programmes. Though the success of these programmes in preventing a severe financial crisis cannot be denied, such actions have resulted in a significant shift in the way markets function. The question is: should the major global central banks continue with the relentless increase in their balance sheets?
The main drawback of this policy is the growing dependence of the markets on central bank liquidity and the misguided perception that the monetary authorities can intervene limitlessly to resolve any crisis. This change in trading mentality does not bode well for the future. In a recent speech dealing with this issue (“Monetary policy in the crisis: testing the limits of monetary policy”) Herve’ Hannoun, a senior official at the Bank For International Settlements, identified the growing risks associated with continuous central bank balance sheet expansion at the 47th conference of governors of the South East Asian Central Banks in Seoul. Haanoun’s key message: “Successful interventions appear to have fostered a widespread but illusory view among market participants that central banks can intervene in unlimited ways and solve any problem.” He further adds that “near-zero interest rate policy and large-scale intervention by central banks in financial markets, while justified and understandable as an exceptional response to the crisis, if prolonged, have adverse side effects that are likely to become harmful”.
The most obvious risk associated with excessive liquidity injection is the (often flawed) perception of a reduction in risk that could induce another round of massive leveraging (borrowing to invest) by financial institutions. The implicit guarantee from central banks that policy rates will remain low and that the monetary taps will be kept open for a significant period of time could encourage carry trades into higher yielding assets. This could eventually result in asset bubbles developing in markets like housing and stocks in emerging markets and commodities across the board. This was fairly evident in a run-up in asset prices in response to the Fed’s two asset purchases programmes of 2008 and 2010 that was followed by sharp corrections thereafter. The more recent rally this year in emerging market assets (despite weak growth prospects) since the beginning of this year in response to the ECB’s LTRO programmes is another example. Asset bubbles fuelled by leveraged trades have a nasty habit of popping unexpectedly and could trigger another round of instability in the markets.
However, another problem that often does not get the attention it deserves is the role that monetary accommodation plays in blunting the fiscal consolidation process. By lowering long-term interest rates, monetary authorities reduce debt servicing costs. In recent years, as aggregate government debt levels have risen significantly in response to the global recession in 2008, interest expenses have actually fallen. This naturally reduces the incentive for policy makers to take tougher decision required to invoke necessary fiscal discipline.
This potential “moral hazard” is useful in explaining the German government’s dogged insistence (that has often come in for sharp criticism) on credible austerity measures for the fiscally-stretched peripheral economies before Germany votes for further monetary accommodation. Similarly, the lower costs of servicing debt (that is currently one per cent of GDP in the US) perhaps explains why US policy makers can afford to take their time over deciding a fiscal consolidation strategy. Finally, rising inflation rates that are inevitable if this glut of liquidity continues could give the markets the impression that policy makers are looking to inflate their way out of the current debt crisis. Markets could react adversely and push yields up sharply on government bonds. This could create all sorts of perverse effects and set the clock back on fiscal consolidation.
Recent commentary suggests that there appears to be some recognition of the risks of untrammelled monetary expansion by both the ECB and the Federal Reserve. Both central banks appear to be reluctant to infuse additional liquidity. The ECB wants to see appropriate implementation of the austerity measures while the Federal Reserve seems to be losing its enthusiasm for additional balance sheet expansion by buying back mortgage securities. Investors that are betting on another round of cheap additional money flowing into the financial system might want to do a serious rethink on whether this is something on which they should bet.
However, while additional liquidity might not exactly gush forth, are central banks likely to reverse their stance and start tightening money supply soon? That is unlikely. The structural problems that are plaguing the developed world are unlikely to get resolved in a hurry. Until some resolution in sight, an increase in rates or a comprehensive winding up of liquidity facilities might not be possible. Global central banks are caught between a rock and a hard place: tackle short-term problems through easy money and fret over inflation or moral hazard later, or start getting tough and risk another crisis in the near term. It is likely that they will plump for the first option. Thus, markets need not worry too much about a rise in interest rates over the next year or so. But at some point they will have to wake up to the consequences of the unlimited largesse of central banks. That is likely to leave them with a fresh set of anxieties.
The authors are with HDFC Bank. These views are personal
