The central bank horror story

Equities, bonds, long-term linked gilts, debt, crypto – the list of dangerous news in the market in 2022 is extensive. However, the biggest problem this year was the reputation of the big central banks.

Since the start of the coronavirus pandemic and the Russian invasion of Ukraine, their inflation forecasts have been off limits. Their response to rising interest rates was slow and, in the notorious case of the US Federal Reserve, initially alarming.

The central banker’s wisdom believed that it was necessary to “overlook” short-term shocks such as rising oil and gas prices and the closure of ports and semiconductor factories because their impact on potential output was temporary.

However it is clear that the shocks and inflation caused by factors such as deglobalisation will lead to a permanent reduction in potential. In such cases, it is the duty of monetary policymakers to tighten so that demand is matched by the decline in production. One of the lessons of inflation in the 1970s after the first oil price hike was that a moderate shock could also, in central banks, offset inflation and lead to secondary effects in the labor markets.

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Recent financial policy mistakes may reflect in part a memory lapse. Very few of today’s central bankers were on the anti-inflation watch after the oil shocks of the 1970s. Overconfidence after decades of deflation was no doubt also a factor. As for the embarrassing initial tightening move, it must be said in fairness that it is very difficult to measure the difference in real time.

Lael Brainard, vice chairman of the Fed, points to the sequence that took place in services, commodities and essential commodities such as semiconductors. This blurred the lines between what creates a temporary shock and the persistence to what can be produced.

The result of all this is that central banks have lost control. At the same time, the tightening of the policy that is about to be done away with will cost them money because the rise in yields will lead to the biggest economic losses on the major bonds that they have acquired since the financial crisis of 2007-09.

Not all central banks can report these losses – there are significant differences in reporting practices. Many would argue that they are not profit-driven organizations and can operate efficiently and fairly. They can’t go bust because they can print money.

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However there may be a starting point where markets fear that a weak economy will lead to inflation or hyperinflation. Turning to finance ministries for funding could reduce central bankers’ reserves of independence since the financial crisis. (This does not apply, fortunately, to the Bank of England, which sought and received compensation from the Treasury against losses in the crisis.)

Such is the uncertainty surrounding the state of advanced economies that there is a risk of over-inflation and recession. A recession in 2023 could reveal the financial crisis caused by extremely low interest rates where investors search for yield regardless of risk.

The prevailing view among central bankers is that since the banking crisis has intensified but the risk has shifted to the non-banking financial sector. There is something to that, as the rising power in the UK pension system exposed in the September gilt crisis showed.

But there are also significant and less visible risks for both banks and non-banking institutions, particularly related to dollar debt in foreign exchange, advances and currency exchange. In a paper for the Bank for International Settlements, Claudio Borio, Robert McCauley and Patrick McGuire show that the $85tn in dollar payments on these instruments exceeds dollar Treasury bills, repurchase agreements and commercial paper combined.

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These positions, which have risen sharply since the financial crisis, are often short-term and often involve conflicts in institutions such as insurers and pension funds. The upcoming requirements make the dollar less valuable, as it happened during the financial crisis and in March 2020 at the beginning of the pandemic. These dollar charges do not appear on the balance sheet and are missing from credit scores. The magnitude of the problem here is obvious.

Meanwhile, market sentiment is that central banks’ “long-term tightening” will keep bond yields higher and the economy lower. But the big question is whether, in the event of a financial crisis, central banks will feel obligated to return to asset purchases to support markets and financial institutions, thereby weakening their anti-inflationary sentiment.

Such a turnaround would be equivalent to a systemic central bank restructuring; essentially returning to a moderately risky asymmetric monetary policy. The concern is that everything is understandable.

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