After the Lehman Brothers bankruptcy on Sept. 15, 2008, financial markets stared into the abyss. Amid the chaos, central banks rose to greater prominence than ever before and have yet to retreat.
Governments felt helpless and put too much faith in central banks, which relished the spotlight. Central bank heads effectively became rock stars, like Mark Carney, formerly of the Bank of Canada and now of the Bank of England, and Mario Draghi of the European Central Bank with his “we will do whatever it takes” speech.
Central banks have the exclusive monopoly to print money. They’ve ended up engineering economic booms and busts. In resolving one crisis, they lay the foundations for the next one. The global economic policy uncertainty index is now at an all-time high.
As U.S. President Donald Trump increasingly shows dissatisfaction with the U.S. Federal Reserve’s tack, the scrutiny of these national bodies with wide-ranging national control of the economy is becoming more entrenched.
Now, as the unwinding of radical crisis-time monetary policy plays out toward a nebulous goal, volatility in financial markets could translate to trouble for Main Street.
Philip Cross, senior fellow at the Macdonald-Laurier Institute and former chief economic analyst at Statistics Canada, says it’s possible that if the economy suffers even more due to central banks’ actions, their independence could be revoked. Independence has long been one of the mainstays of central banking.
“It’s much more likely that, rather than going back to some rules-based policy, that politicians would simply want a seat on the board [of central banks],” he said in a wide-ranging interview.
Since the financial crisis, central banks have been the driving force behind asset prices—from stocks and bonds to houses. People have grown accustomed to historically low interest rates and large-scale bond purchases juicing markets. It has encouraged governments, companies, and households to pile on debt.
A moral hazard issue has been introduced in that as debt piles up, it puts the stability of the financial system at risk. And if the debt bomb blows up, it’s the taxpayer who is left holding the bag. Politicians want more accountability from central banks.
Central banks target 2 percent inflation, but the kind of inflation they target is questionable. Post financial crisis, inflation as defined by consumer prices has languished. But the same can’t be said for stocks, bonds, or houses.
Boom and Bust
After the tech stock boom of the late 1990s and the dot.com bust of 2001, the Fed essentially sowed the seeds for the subprime mortgage crisis, which led to the global financial crisis of 2008.
“Every time that we have a major crisis, we adopt policies that lay the groundwork for the next crisis,” Cross said. “You can trace that all the way back to 1982.
“Once you get on that treadmill, it’s very hard to get off.”
The consequence of over-reliance on central banks has been that their short-term boosts to the economy weaken long-term economic prospects.
Monetary policy globally was in uncharted waters and is trying to get back to a “normal” level of interest rates. And for the Fed reducing the size of its balance sheet, it was always going to be painful and rife with uncertainty.
“They [central banks] were never very upfront about what are the limitations of monetary policy. And they’re considerable,” said Cross.
In the spring of 2013, the Fed tried cutting back (tapering) its bond purchases. This resulted in the “taper tantrum” as stock and bond markets—like a drug addict suffering from withdrawal symptoms—started collapsing.
In the aftermath of the crisis, some commercial banks became deemed “too big to fail.” No need for another Lehman-type failure, as these big banks had become so systemically important, creating a vicious cycle of dependence between them, central banks, and the government.
Now, as central banks try and clean up after the party again, the mythical neutral rate is often referenced as their Holy Grail. The logic is that the Bank of Canada and the Fed intend to raise rates until they reach some unobservable equilibrium level.
“Why not focus on something that we can measure and we know is definitely a problem for the economy if it gets advanced?” said Cross.
What Are They Saying?
Central bank communication isn’t the elephant in the room, but it can be frustrating for investors to decipher, which leads to uncertainty in financial markets and the economy.
The volatility at the end of 2018 stemmed in large part to Fed chair Jerome Powell’s poor choice of words in early October regarding the neutral rate. Powell said rates were a long way from neutral, meaning more rate hikes were needed. He has since gone to great pains to walk back that talk and now markets feel he’s got their backs once again. But should this even be the case?
Bank of Canada governor Stephen Poloz has been criticized for trying to engineer a low dollar to boost exports and for surprising markets in 2015 with two rate cuts. But on Jan. 9, he defended the addition of “over time” in a sentence about rates needing to rise to hit neutral.
Poloz admitted the addition was to “introduce a degree of ambiguity” for the next rate hike. The Canadian dollar rallied as traders expected higher interest rates even as inflation remains in check.
“I don’t find central bankers talking enough about there’s only a limited amount of things we can do,” Cross said. “They never sat down with people and said, ‘Here are our limitations.’
“They welcomed the adulation.”
Given concerns about central bank independence and authority, financial stability, and the misleading interpretation of inflation, a re-examination and potential reining in of central banks seem judicious.
“History shows monetary regimes last about 30 or 40 years, followed by a decade or so of chaos as we flounder to find a new regime,” Cross said. “I suspect we are in one of the latter periods now, struggling to find a new approach to monetary policy.”
Follow Rahul on Twitter @RV_ETBiz