With the covid crisis, central banks have taken center stage and poured trillions of dollars into stocks and bonds. In the process, monetary policies somehow got mixed up with fiscal policies. A red line was crossed, experts warn.
The covid-19 crisis took us to extremes in terms of monetary policies. Central banks have taken center stage. They have become the tap that governments turn on to meet all the needs of markets and the real economy, in what seem unlimited amounts. The Fed bought not only sovereign bonds, but also corporate bonds, and more importantly, non investment grade bonds, like high yield debt and commercial paper.
Both the Fed and the Japanese central bank have been buying ETFs. Central banks (notably in England) extended direct lending to the government. They increasingly got into «deficit financing», which is the traditional preserve of governments. But the rule of the game is that there can’t be direct financing of public spending by central banks. Public finances are supposed to clearly take over after the peak of the crisis.
In order to preserve central banks’ credibility, the natural boundaries between fiscal and monetary policy need to be fully restored. In the same way, central banks cannot intervene in government debt markets on a large-scale and long-lasting basis without worrying about the consequences. The risk of such policies is the loss of credibility and independence of monetary institutions.
From now on, the major economies face two paths. Either they form bad habits and become permanently dependent on money creation for solving all issues, which would end in disaster, or central banks revert back to normal and remain within their mandates. The credibility of the monetary system is at stake. What was a crisis tool cannot become a permanent fixture.
Some of these concerns were expressed by the most legitimate voices. During a May 27 UBS webcast, Thomas Jordan, chairman of the Swiss national bank, started by saying that «massive reactions of central banks were warranted» to respond to the pandemic crisis, and even that «additional measures should be taken if needed». But he stressed that the role of the SNB was to contribute to the management of the crisis within the scope of its mandate.
And that is to ensure monetary conditions remain accommodative, using negative interest rates. He argued that negative rates, in the case of Switzerland, are the SNB’s main tool to counter the upward pressure on the Swiss franc, while they also offer favorable borrowing terms to the federal government and local authorities. But Jordan also stressed that central banks in general must remain independent, and that the separation between monetary and fiscal policy must be respected: «policy measures of governments and central banks should complement each other», he said.
Central banks are there to solve liquidity problems and manage financing conditions, while governments should take care of solvency issues and subsidies. Central banks, he added, should abstain from open or hidden financing of public spending. Transfers from central banks to governments should remain within the constitutional setup.
Sitting next to Thomas Jordan that day was Agustín Carstens, general manager of the Bank of International Settlements (BIS), who made the trip from Basel to Zurich to attend the UBS webcast. Similarly, he started by stating that large-scale government bond purchases by central banks were needed to keep long rates low, provide monetary stimulus, keep sovereign bond markets liquid and functional, and help governments – as fiscal deficits rise and debt levels surge – fund their huge borrowing needs.
However, he too highlighted a «significant overlap between fiscal and monetary policy». He stressed that the role of central banks as financing intermediaries between fiscal authorities and financial markets should be «temporary and limited by its intent and size and should be in line with the financial stability mandate of central banks». The bottom line, he said, is that this type of monetary actions «intend to safeguard economic and financial stability, not fiscal deficit financing». The minute that monetary actions are over and the liquidity phase is through, then «for subsequent phases, the heavy lifting should be primarily ensured by fiscal policy and structural reforms».
«There is a growing nexus between fiscal and monetary policies», says Augustín Carstens. «How can we safeguard central bank independence and credibility going forward?», he asks. First, fiscal sustainability should be assured, or perceptions may arise that that could be inflated away, he says, and central banks need to get back focusing on their traditional tasks, inflation and financial stability. The word «deficit financing» should be avoided, and an exit strategy should be articulated as soon as possible.
One of the challenges brought by these policies is the substantial growth of central bank balance sheets, in tandem with the massive increase in public debt. The chairman of UBS, Axel Weber, agreed with the previous remarks on the webcast and added that the Fed balance sheet went from 4200 billion dollars to 7100 billion, a 2,9 trillion increase, and was expected to surpass the 10 trillion mark by year-end. Almost 2 trillion of that increase are made of US treasuries, which helped fund the scale of expenditures. To Weber, these policies blur the lines between fiscal and monetary policy. In his view, there has to be limits to this debt monetization. «Central banks need to steer a very clear course, and focus on their independence».
The dollar, in particular, has to remain stable, being the reserve currency of the world, or it can endanger and impact the stability of the entire monetary system, says the former president of the Bundesbank. Weber sees limits to the risks central banks should take on their balance sheets. «The larger the balance sheet, the more you intervene in markets that are non standard transmission channels for monetary policy, like US intervention in non investment grade markets. To the degree that it provides a backstop, it stabilizes markets and market expectations, but it also comes with an unprecedented amount of risk».
The German economist is concerned about the acceptance of market players – he seemed to be alluding to China – to basically hold and continue to buy and feel comfortable with US assets. «So far, so good», he says, but he warns against taking this too lightly. «Don’t take markets for granted to be there in the future; everyone assumes markets will be there to backstop governments and to hold the debt appropriately, but you have to earn that confidence of the market everyday».
The message is clear. Central banks have crossed some red lines. These policies only make sense if they are temporary and can revert to normal after crisis times. If they last too long, there might be no exit possible.