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Thought of the Week: Back to School: Summer Vacation Ends for Central Bankers, 09.10.2012
View All Previous TOTW Articles| Andrew Boczek Vice President, Portfolio Manager of the International Equity Fund Sentinel Asset Management, Inc. The heady days of "Maestro" Alan Greenspan may be long gone. Nonetheless, most of us still take for granted that similarly wise men and women, aloof from the pressures of politics and short term market fluctuations, have the capacity to set the proper price of our most precious commodity: time. Or said another way, to set an effective interest rate policy that encourages either savings or spending, today or in the future, to help manage long term economic stability. And there remains a persistent view among investors and market commentators that central banks have the power to rescue markets, if only they have the will to do so. Given the global rally in stocks last week in the wake of the European Central Bank's (ECB) addition of Outright Monetary Transactions (OMT) to the alphabet soup of "extraordinary" policies, and in anticipation of a third round of "Quantitative Easing", already nicknamed QE3, by the US Federal Reserve, the markets certainly seem to think so. But is such hope warranted? In order to answer this question it's helpful to understand the origins of central banking and what central banks actually do. If we think back to the era of the pure gold standard, before modern central banks existed, we picture a world where growth in the monetary base was limited by man's ability to dig more of the yellow metal out of the ground. Money sloshed around the world, chasing opportunities and leading to bubbles and busts as banks here or there expanded the broader money supply by extending credit and taking deposits, but the total supply of gold in the world didn't change much from year to year. On one hand, in the absence of central banks, such business cycles were necessarily self correcting, and so tended not to last long. On the other hand, the strains that the resulting volatility placed on financial systems and economies shouldn't be underestimated. When asset prices corrected, commercial banks could be wiped out, often taking down not just greedy bankers but innocent depositors as well. Not surprisingly, commercial bankers weren't particularly fond of this state of affairs and neither were democratically elected politicians. Through the creation of a lender of last resort, governments would allow for an elastic money supply, helping prevent liquidity crises from turning into serious economic downturns and, not coincidentally, providing job security for commercial bankers. A central bank run by wise men sounded like just the antidote to recurring periods of economic depression. The United States Federal Reserve was part of a wave of central banks that were created around the world in the early 20th century. So how do central banks perform their magic? In theory, by buying approved financial assets from or selling and lending them to the banking system, central banks are able to set the level of reserves on bank deposits that constitute the most important part of the monetary base in a modern economy. In practice, the authorities usually establish a level of interest rates that corresponds to a desired level of reserves; but the result is the same. These reserves are the raw material for credit creation by the commercial banking system, which drives broader money supply growth and ultimately inflation. ( "Quantitative Easing" (QE) is simply an effort to further increase reserves once interest rates have reached the lower bound of zero by using unconventional asset purchases such as longer dated government bonds or mortgage-backed securities.) It should be stressed, however, that though it can increase bank reserves at the stroke of a pen the central bank can not make the banking system lend and therefore has limited control over the broad money supply. That is because commercial banks have two other important binding constraints on lending: their level of available capital and the existence of creditworthy borrowers with good collateral. And these constraints are precisely why the huge growth in bank reserves in the US over the past five years has not led to any significant growth in bank lending. The fact remains, however, that the monopoly power over base money creation clearly creates the potential for mischief and bumps up squarely against the fiscal role of government. Lessons have been learned from poorly constituted central banks which crossed this line between monetary and fiscal policy---many of us have read about the experiences of Weimar Germany in the 1920s, Latin America in the 1980s and Zimbabwe in the last decade. Consequently, central banks are usually constrained by law as well as political considerations. For example, a central bank might be limited in the type of financial assets it can own or in its ability to buy debt directly from the government---importantly, modern central banks are meant to be politically independent. Essentially, the modern central bank can only impact the economy in two ways. The first and most obvious way is by shifting an economy's purchasing power across time. In the absence of a central bank, interest rates would reflect the supply and demand for savings in an economy and thus balance society's aggregate preference between consuming now or spending later. Higher interest rates are an incentive to save more today and thus delay spending for that rainy day in the future; whereas lower interest rates are an incentive to spend/invest more today, and worry about saving later. The intersection of these savings and investment functions determines the natural interest rate. Thus, if the central bank sets rates too low, then the economy will behave as if it has more resources available than it does, leading to a bubble in consumption and/or investment---purchasing power shifts from the future to the present. Normally, a side effect of this rise in demand relative to resources would be increased inflation. The other way in which central banks influence economic behavior is by shifting purchasing power between creditors and debtors. By setting rates below the market rate, central banks are, in effect, forcing lenders to subsidize borrowers and creating a transfer of real resources from creditors to debtors. Keep in mind, however, that any intervention favoring particular classes of creditors or debtors is considered an encroachment on fiscal policy. Central banks (in democracies) can't force commercial banks to make loans to favored sectors, for example, or make loans directly to borrowers, including the government. But in times of financial stress there can be a fine line between fulfilling its responsibility of maintaining confidence in the financial system and acting as a fiscal branch of government. All of which brings us to our current circumstances. Although the world's major central banks continue to hold rates close to zero, an acceleration in growth remains elusive for key economies, including the US, Japan, and of course, Europe. Thus, we have seen speculation increase that the Fed will soon implement another round of QE, or QE3. And last week, amid much fanfare and to the delight of markets everywhere, the ECB announced a policy of potentially unlimited purchases of peripheral government debt, the so-called OMT. So hope springs eternal that, once again, the monetary authorities will ride to the rescue of struggling financial markets. Given the above framework, however, it is clear that there are both institutional as well as practical limits to what central banks can do, regardless of what US Fed Chairman Ben Bernanke or ECB President Mario Draghi say. Note that the level of reserves in the US banking system is, in no way, a constraint on bank lending today, so any further QE is unlikely to change the behavior of banks or borrowers in the near term. With interest rates already close to zero, we have already maxed out on borrowing purchasing power from the future. Furthermore, on closer inspection, the ECB's new OMT policy may be less than it appears to be. For example, the program imposes significant conditionality on the governments of participating countries, limiting its expansionary effect; and in any case, the intervention is meant to be fully sterilized, meaning that the central bank intends to sell other bonds in proportion to its purchases of peripheral country debt, thus keeping reserve levels constant. As discussed above, such a policy treads dangerously close to choosing winners and losers, which is ultimately the role of fiscal policy. In the long run, this has the potential to undermine confidence in the ECB's independence, putting at risk its ability to fulfill its real mandate of protecting the purchasing power of the euro. Bottom Line: Key economies remain locked in a battle between the deflationary force of excessive debt levels and the inflationary policy response of extraordinary monetary easing. Ultimately, time remains the most precious commodity. Absent further unorthodox monetary policies that encroach upon the fiscal role of governments, we need time to increase savings to fund debt payments, and we need time for moderate inflation to gradually erode the value of the debt that weighs down much of the developed world and prevents a stronger economic recovery. Patience is required. |
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