World Economy

Credibility of CBs in Doubt

Credibility of CBs in DoubtCredibility of CBs in Doubt

The central banks remain in control of the markets as since 2008 it has been up to them to patch the global economy back together again. Unfortunately, as was learned back in the Great Depression, monetary policy is not very effective at stimulating growth.

Banks trying to work off bad loan portfolios are not likely to be aggressive lenders, and potential borrowers tend to restrain their consumption as they try to dig themselves out of a hole, Nasdaq reported.

The answer is usually that the economy needs a significant fiscal stimulus, but most countries are reluctant to spend because they face significant budget deficits because of reduced tax collections. This is the dilemma that just about everyone is facing at the current time.

The worry now is that the global economy might be moving into a recession. Fresh monetary stimulus were seen recently from the Bank of Japan, Bank of England and Reserve Bank of Australia.

Next week, the Reserve Bank of New Zealand is expected to cut rates. Also the European Central Bank has already been running a negative interest rate scheme. Furthermore, Swiss bond yields are negative all the way out to the 30-year maturity.

Losing Credibility?

Since the financial crisis of 2007-2008, central banks of the world, especially the “big four” Federal Reserve, European Central Bank, Bank of England and Bank of Japan, saw their role in achieving economic stability becoming increasingly important. They have two main goals: price stability, with an inflation target of 2%, and full employment, The Market Mogul reported.

However, as the recent years have shown, with people having no confidence in the global economy, these targets proved difficult to achieve. For this reason, central banks were forced to implement unconventional monetary policies, after the standard ones proved ineffective.

With interest rates approaching negative territory, the institutions had to find another solution to achieve their goals. In this sense, the Fed is a pioneer, implementing its first round of QE in March 2009. This policy consists of central banks purchasing assets, chosen from a basket of eligible ones (especially government bonds, but also corporate more recently) with newly printed money in order to try and increase liquidity and promote investments and economic growth.

The Fed implemented the measure for about one year, through the monthly purchases of $30 billion worth of T-Notes. This operation was repeated three times, with a Fed balance sheet post-QE five-times higher than the pre-QE one. The BoJ, the BoE and the ECB purchased bonds too, with the BoJ leading the pack after a monstrous purchase worth ¥443 trillion ($4.3 trillion).

The Role of Expectations

Although it is true that most of the job is done through actually implementing the measures, one key role in economics is played by expectations.

For people to change their mind about future economic situations, they need to receive their news from institutions they trust. This is the reason why most of the central banks try to be as clear and as transparent as possible about future maneuvers so as to manage expectations follow the right path.

However, in the last year, one has seen unusual reactions from financial markets to some of the announcements–for example, the yen moving 2% in the wrong direction against the dollar after the BoJ relaxed its monetary policy or the ECB announcement of a new wave of QE taking its toll on the euro/dollar pair.

Despite this, central banks still have enough credibility to change people’s expectations, but one should analyze these unexpected and adverse movements in financial markets and see them as symptoms of a system that is not working at its best.

In the last months, people started talking about a new frontier in unconventional monetary policies: helicopter money, consisting of central banks lending directly to customers.

Despite the fact that this idea started to get traction, most of them consider it unfeasible because it will be synonymous with a defeat and the end to central banks’ credibility. And that does not even take into consideration the economic risks of hyperinflation and speculation.