Blurred lines as central banks prop up the world after Covid – but who pays?
‘It sort of looks like an official Ponzi scheme and that is a little bit worrying from a financial point of view’
‘By keeping gilt yields low, the inevitable day of difficult fiscal decisions is just moved further down the road’
Covid-19 has upended the world. “The New Normal” is a 10-part series looking at the ramifications for global economics and business, from rising debt to the impact on trade, the hit to the hospitality sector and the nightmare facing the aviation industry. The series begins with a look at the astonishing costs being run up to pay for the outbreak and who will pick up the bill.
While politicians around the world have been throwing trillions at Covid-19, it has been central bankers writing the cheques. Once, before the financial crisis of 2007, “unconventional” monetary policy was exactly that: an emergency tool only used by Japan in its decades-long fight against deflation. Since then, previously outlandish measures such as quantitative easing (QE) to buy up government debt in order to help push down interest rates have become commonplace.
The emergence of the outbreak has given the balance sheet of the world’s central banks a further leg-up, bringing the combined total to around $30 trillion (£23 trillion), or around one third of global GDP. But when the Federal Reserve is even willing to buy small business loans and municipal debt along with government bonds, has Covid irrevocably blurred the boundaries between monetary and fiscal policy? Has central bank independence become a shibboleth, and who pays the price?
First, we have to place the Covid-19 crisis against a backdrop of secular trends pushing down the natural or “equilibrium” rate of interest, known as r*, for decades: that is, the rate at which the economy can achieve trend growth without fuelling inflation.
Reasons such as an ageing world population – and hence a higher demand for savings – as well as lower trend productivity reducing demand for capital from businesses have pushed down r*, which was estimated at between 0pc and 1pc in 2018. In that context, it is unsurprising that central banks around the world struggled to lift interest rates off the zero lower bound since the financial crisis.
But the virus – as with so many other aspects of the economy – is likely to accelerate that trend. Research by the University of California’s Oscar Jorda into previous pandemics suggests a “long economic hangover” from Covid-19.
His study of previous outbreaks over the past millennium shows the natural rate of interest falling by as much as 2pc in the decades following due to a surplus of capital versus diminished (or deceased) labour, as well as increased precautionary savings. “Survivors may simply wish to rebuild their wealth or may just be more frugal out of caution,” he writes.
The mitigating factors against the trend are that modern medicine will mean a far smaller death toll from Covid than, for example, the Black Death. It is also deadliest to older people out of the workforce, while aggressive fiscal expansion to fight the virus will push against the downward trend.
But still the job of central bankers has become that much more difficult, with rates being cut by just 0.65 percentage points this year by the Bank of England, compared to 5.25pp from the peak in 2007 to the postcrisis trough in 2009. Hence why QE has been the go-to tool for stimulus.
Threadneedle Street insists on its operational independence, but it has not escaped the attention of commentators that its QE purchases since March have broadly matched the Treasury’s own frantic gilt issuance to pay for both Covid-19 support measures and the black hole in revenues caused by the shutdown of the economy.
The Bank’s insistence that it buys in the secondary market rather than directly from the Government – as well as Governor Andrew Bailey’s recent assertion that the central bank will not be there as a backstop forever – is also being greeted with some scepticism.
According to Takashi Miwa, an economist at Nomura, the “dismount will be difficult” for central bankers as higher debts in turn mean a harder time dealing with higher rates, so “we are likely stuck with unconventional monetary policy for many years to come”.
He says: “The distinction between central banks and governments has likely blurred. Central banks will be supporting large budget deficits for many years to come, and the line for most – in only buying in secondary markets – looks pretty thin, with brokers/investment banks being the temporary intermediary.”
Andrew Sentance, a former Bank of England rate-setter at the hawkish end of the spectrum, says independence has “definitely been eroded” and argues there is “something slightly unnerving” about the Government selling gilts and the Bank of England buying them virtually in lockstep: “It sort of looks like an official Ponzi scheme and that is a little bit worrying from a financial perspective.”
But the threat of a surge in inflation from the trillions in stimulus is – so far at least – the one dog that hasn’t barked in this crisis, raising questions over the nature of independence when central banks are now such a key prop. Sentance adds: “When we come back to reconstitute economic policy after this current crisis, maybe we will decide that central bank independence is not as important as we thought it was in the past. It was, after all, a reaction to the inflation excesses of the Seventies and Eighties – we haven’t had them.
“Maybe we need to have a different framework for monetary policy in the new normal. I don’t think that is a threatening or improper thing – it depends how it is put in place.”
The longer-term consequences of extended QE however could be profound, as central bank spending supports asset prices and enhances the distributional divide between the haves and the have-nots. That will further accentuate the chasm between, for example, the homeowning white collar workers in the south and the furloughed younger restaurant staff facing unemployment up north.
Simon French, Panmure Gordon’s chief economist, says “no reasonable person” would argue that the Bank of England should have held off shortterm action, but underlines the importance of why inflated bank balance sheets matter “massively”. He warns: “By keeping gilt yields low, the inevitable day of difficult fiscal decisions is just moved further and further down the road.
“Arguably this just stores up intergenerational problems that fall more on the current working age generation, rather than the gilded baby-boom generation. The long-term legacy of this is quite problematic. Difficult decisions are just kicked down the road. Economists and academics worry about the independence of the institution but there is also some relevance for Joe Public here in terms of who is ultimately going to pay the bill? The bill isn’t paid by QE, it is deferred by QE.”
The younger generation – likely the biggest casualty in educational and economic terms – appear to be on the hook.
Christine Lagarde, now the ECB president, with some of the world’s financial leaders, including Bank of Japan governor Haruhiko Kuroda and US Treasury secretary Steven Mnuchin, at a G20 meeting