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’

The Daily Telegraph - Business - - Business - By Rus­sell Lynch ECO­NOM­ICS EDI­TOR

‘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

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