When commercial banks get into trouble, their last resort when all else has failed is to turn to their central bank. But another group of banks is in trouble now – the central banks themselves.
Current central bank policy is rapidly resembling a dead end. It is not working, it is not stable, and it is not sustainable. Their balance sheets are bloated, their position in financial markets uncomfortable. Negative interest rate policies are causing mounting damage to banks, pension funds, insurance companies, and the workings of capitalism itself. Not a single person in all of finance believes that a situation in which large swathes of government bonds have negative yields is either sensible or healthy.
There is a significant risk that central banking is following ‘the route of the three Ds’. First, they tried through forward guidance to Direct markets, then through QE and other market interventions they aimed to Distort markets. And now many fear that, through their dominant position in many asset classes, there is a growing danger they may Destroy markets.
The latest central bank initiative, this time from the Bank of Japan, threatens to make markets even more artificial. With its stated aim of keeping Japanese government bond yields for all bonds up to 10 years in maturity below zero, the BoJ is now nakedly manipulating the bulk of the JGB yield curve. But when the markets no longer consist of a willing buyer and a willing seller transacting on the basis of value, there is no guarantee that the market price is a fair price and no concept of fair value for investors.
Furthermore, the more that central bank activity dominates markets, the less those markets can provide any form of independent opinion or signal back to the central banks. As someone at a major central bank lamented to me, ‘when all you hear is an echo of your own acts there is no information’.
All this is not news. For at least five years, investors have been asking, ‘How long must we put up with these ultra-low interest rates? How long before we return to normal?’ It is scant comfort that central bankers have been asking themselves very similar questions for at least as long, not least because they are struggling to see the answer too. But the questions are growing in urgency as the effectiveness of repeated rounds of stimulus fades and the collateral damage to the financial system becomes ever more difficult to ignore.
This cannot go on. And there is a maxim that things that cannot go on usually do not go on. But it is very difficult to see the central bank exit strategy and a controlled route to a more stable environment. The greater the distortion from fair value, the sharper and more uncontrolled any reversion to normality threatens to be.
Central banks need to work together to find a way out of their predicament. If any single central bank were unilaterally to raise rates to more orthodox levels, it would cause turmoil in the markets and a major surge in their currency, neither of which any central bank – even one as powerful and domestically orientated as the US Federal Reserve – can contemplate.
And the thought is growing that, even if central banks were to act in complete unison, this may not be enough. What is needed is international recognition that monetary policy cannot carry the whole burden of reviving economies any longer; that there needs to be more balance between monetary and fiscal stimuli; and that the central banking community needs political help to avoid the response to the Great Recession ending up worse than the original crisis it set out to solve.
John Nugée is a Director of OMFIF and a former Chief Manager of Reserves at the Bank of England.