Central bank heads were once a predictable and conservative lot. Now they’re swooping in, buying huge amounts of securities and rolling out unorthodox policies to avert danger.
In days of yore, the role of a central bank was straightforward, clear-cut, even pedestrian. In normal times—that is, when interest rates were in positive territory and markets were relatively calm—a central bank raised benchmark rates when inflation appeared on the horizon. If the economy started to slip, it lowered rates.
All that went out the window in 2008. Once the global financial crisis struck, the US Federal Reserve Board resorted to quantitative easing, propping up American markets by buying more than $3.5 trillion in government-issued bonds. Since other central bankers have almost no choice but to follow the Fed, this policy triggered a global shopping spree that continues today.
Since 2009, the Bank of England has accumulated £375 billion ($574 billion) in government-issued bonds. Over the past few years, the Bank of Japan has added a private-sector ingredient to the mix, investing about ¥2.8 trillion ($23 billion) in exchange-traded funds that track Japanese stock indexes. In January the European Central Bank started buying €1.1 trillion ($1.2 trillion) worth of bonds, including covered bonds that are issued by European banks and backed by mortgage loans. In July the People’s Bank of China (PBoC) raised the stakes dramatically, plunging 100 billion yuan ($16.1 billion) into publicly listed Chinese shares in a bid to stave off a stock market crash.
“They’re presenting themselves in really a whole new role as superinvestors,” declares Ulrich Bierbaum, general manager of Dagong Europe Credit Rating, the regional office of the Chinese ratings agency, in Milan. “The valuations of so many asset classes are dominated by the policy of central banks, leading to a situation where, in some asset classes, the private investor has no possibility to get the asset at the price that he would normally pay.”
The People’s Bank may have had little choice. A plunging stock market could sap investor and consumer confidence and, in the process, take the Chinese economy down with it. And economists do believe the PBoC started off on the right foot in late August by lowering reserve requirements and cutting its key lending rate by one-quarter of a percentage point to encourage banks to lend money to companies. The move was primarily aimed at boosting corporate investments in factories and real estate. The central bank further aided Chinese manufacturers by devaluing the renminbi, China’s currency, by nearly 2%, making their exports more competitive. “We expect the People’s Bank of China to continue to ease monetary policy to support growth and manage downside risks to the economy from China’s stock market meltdown,” says Bill Adams, senior international economist at PNC Financial Services Group in Pittsburgh, Pennsylvania.
Even superinvestors have limited powers in the face of market forces, however. Many observers doubt that the PBoC will be able to keep China’s economy on track. Louis Lam, an economist at ANZ Group in Hong Kong, predicts that China’s economy will grow by only 6.8% this year, or 0.2% less than Beijing has said it would. “China will likely miss its growth target, which is one of the biggest targets that the authorities set,” says Lam. “This could be a blow to the authorities’ credibility. If fear starts spreading too fast, the PBoC will have to stay in front of the curve, aggressively easing policy.”
The big concern is that the fear factor could unleash a global market contagion that no central bank is equipped to fight. “If the market panic that appears to have started in China and spread to Europe and the States continues, we are in a very serious situation,” says Roger Farmer, a professor of economics at UCLA who serves as a consultant to the Federal Reserve Bank of Atlanta, the Reserve Bank of Australia, the European Central Bank and the Bank of England. “I don’t think anybody knows what they are going to do about it.”
OUT OF AMMO
Old tactics may no longer be available. The buying binge has left central banks bloated with assets, which could make it tougher for them to raise interest rates to stimulate economic growth. “Larger balance sheets could have implications for their finances and cause problems when it comes time to normalize the level of interest rates,” says Barry Eichengreen, a professor of economics and political science at the University of California, Berkeley. Unlike the PBoC, whose key lending rate was 4.6% even after the reduction in August, the Fed and other central banks have cut rates so close to zero that they have no room to lower them. Without that silver bullet, central banks are finding it difficult to persuade corporations to borrow money and then invest it.
The big challenge here is that short-term interest rates are a function of supply and demand. Before the implosion of 2008, the US central bank used to adjust short-term rates by adjusting the money supply, in the form of bank reserves. “But now the supply is way, way above the demand—trillions of dollars above,” says John Taylor, a professor of economics at Stanford University and a former US under secretary of the Office of the Treasury for International Affairs. So to raise interest rates now, reducing the supply of reserves won’t do any good.”
The only way the Fed can raise rates now is to pay banks higher interest on their reserves. In theory, that should trigger a domino effect that boosts short-term rates. In reality, it’s no sure thing. “It’s going to be the first time of this magnitude,” says Taylor. And even if the play works, higher rates will raise the cost of financing the US government’s debt. “People will ask about the political socioeconomics of that,” Taylor says, adding that if the Fed decides to postpone plans for a rate hike in September, these issues might well have factored into the decision.
The Bank of Japan, meanwhile, appears no closer than the Fed to hiking interest rates. The strategy is hard to fathom, given the widespread recognition that inflationary measures are desperately needed to shake the economy out of two decades of deflation. “The role of central banks has changed,” says Hitoshi Itagaki, president of Principal Global Investors (Japan) in Tokyo. “They used to be inflation fighters. But now they are deflation fighters.”
In Europe the combination of the ECB’s interest rate paralysis and the devaluation of the renminbi, which has made European exports to China less competitive, is discouraging manufacturers from plowing capital back into operations. In particular, analysts say auto and auto parts manufacturers, as well as companies that make factory equipment, are putting off capital expenditures. “If you have too much information and too many doubts, you just hold back some of your investments,” says Dagong’s Bierbaum. “If investments come down significantly, that means we are not getting off this carousel, because you cannot really see what will stop the argument for maintaining quantitative easing.”
If central banks come away from this year’s turmoil with a single lesson, according to Eichengreen, it will be that “simple rules don’t mesh with complicated circumstances.” Certainly, it’s unclear if the quantitative easing methods that the PBoC is deploying—and that have only been tried in developed markets like the US and Western Europe—will do the trick in an emerging, volatile market. If they don’t, buckle up. Says Mark Zandi, chief economist at Moody’s Analytics in West Chester, Pennsylvania: “Central banks are on high alert.”
