What central bankers don’t understand about markets

WHEN chairman Jerome Powell announced after last Wednesday’s Federal Open Market Committee meeting that the Fed is “committed to using its full range of tools to support the US economy in this challenging time”, the market interpreted it as the Fed would do “whatever it takes” to support the United States facing the worst pandemic and economic recession since the 1930s.

Since the beginning of this year, the Fed has expanded its balance sheet by an unprecedented US$3 trillion to just under US$7 trillion by buying US treasuries, mortgage securities and commercial debt. The top four central banks (Fed, European Central Bank (ECB), Bank of Japan (BOJ) and People’s Bank of China) have added US$6 trillion to their balance sheet size since the beginning of the year to US$25.2 trillion or 28.7% of 2019 world GDP. That is serious money (your money)!

What are the effects of such central bank action? First, inflation remains low, because there is a lot of excess capacity due to lockdowns. Second, stock market prices are near record highs and most have recovered from the March 2020 dip because of excessive market liquidity. Third, interest rates have become near zero or negative, taking out the pricing or resource allocation role of interest rates.

Interest rates are kept low because the central bank is willing to supply liquidity to keep rates low. Central banks are now the largest buyers of government debt, commercial and mortgage paper, so they have become not a “lender of last resort” but major player in the market. Basically, because central banks will do “whatever it takes”, investors no longer look at interest rate signals to decide what to buy, just follow what the central bank does.

During the 1990s, the market began to follow the Fed for what became known as the “Greenspan put”, meaning that investors expected then Fed chairman Alan Greenspan to cut interest rates to stop the market wobbling. Even though this was more “signalling” rather than serious action, hints of interest rate cuts were enough to steady nerves. But over-used medicine become like drugs, you have to take larger doses to have less and less effect, but everything then goes downhill.

In the 2008 global financial crisis, the Fed and ECB borrowed the idea of quantitative easing from the BOJ, the first to bring interest rates to near zero and to use its balance sheet to create easy money conditions to help Japan recover from deflation. Between 2001 to 2020, Boj’s balance sheet expanded from 20% to over 107% of GDP, whereas the Fed grew from 6% in 2005 to just under 20% of GDP. It may be pure coincidence, but the price of gold rose 28.9% since the beginning of the year, whereas the annual growth of big four central bank assets to June 2020 was 28.8%. The gold price is an indicator that people are losing trust in central bank money.

Global governments have committed US$11 trillion of fiscal measures to tackle the pandemic crisis, of which half are additional spending and tax cuts and another half are loans, equity and guarantee support for jobs and companies. As a result, advanced countries are running fiscal deficits at 16.5% of GDP and total debt would touch 130% of GDP, the highest since wartime financing. Such deficits and debt are only possible because central banks fund half of the fiscal spending. Without that, interest rates would be higher and governments would be in dire straits.

Rescuing the economy looks laudable, but there is a fundamental cost. A Netherlands central bank study (2019) on a century (1920-2015) of data showed that expansionary monetary policies increased the share of the top one per cent’s income and wealth by roughly 1 to 6 percentage points. The biggest wealth effect comes from asset bubbles, which benefit the top 1%.

In effect, loose monetary policy rewards borrowers and punishes savers, worsening social inequality. Global interest-bearing deposits are roughly US$60 trillion held mostly by low and middle-class people who live off deposit income. A 1% cut in deposit rate cuts their annual income by Us$600bil and subsidises the borrowers.

Recent action by central banks to cap or stop banks giving dividends in order to “preserve their capital buffers” is a classic example of excessive nannying by central bankers and financial regulators that weaken the ability of free markets to respond to risks.

Retail and institutional investors like bank shares because they are leveraged diversification plays on the real economy. Bank stocks are blue chips that pay steady dividends. When troubled times come, good banks survive and will do better on recovery. But if you restrict their dividend income payout, then retail investors cut off from steady income from bank deposits are forced to go into the stock market and punt tech stocks that have price earnings ratio of over 40, some with no revenue or dividends and with business models that few understand. The minute dividends are cut, the share price drops!

In other words, if you remove the safe haven role of bank blue chips, prudent investors are fed to a world where they become speculators in a bubbly market, created by excessive low interest rates. Let bank boards decide what their dividend policy should be. Let investors judge whether they trust that management to control their credit risks.

If the bank doesn’t want to pay cash, let them pay out in stock, and go to market for rights issues if they feel that their capital is insufficient. But by capping dividends, the financial regulators are signalling that they know better what the risks are than the market. That is not a vote of confidence in the banks or the quality of their bank supervision.

Central bankers have become nannies who preach free markets, but don’t trust the market. By rescuing the market so often and growing so large, they are becoming the market, but still say that the market must bear the ultimate risks. In effect, they bail out the smart money and pass the losses to gullible ones who believe that the central bankers understand what they are doing.

No wonder the financial world is in deep trouble.

The views expressed here are the writer’s own.