Central Banks: Navigating the Crisis Ahead

In March 2020, when a significant portion of the world’s economy shut down in response to the spread of Covid-19, it was central banks, not sovereign governments, that initially stepped up to avoid a complete financial meltdown.

The same thing happened following the 2008/9 financial crisis and has been happening on and off ever since. Crises move quickly and politicians do not, due to a combination of partisan paralysis and the need to pass laws rather than act by decree.

The world’s central banks were in the process of tightening their policies again after a decade of pumping cash into their economies when they promptly reversed course and once again stepped up their purchases of assets from banks and financial institutions. Some, like the Fed, didn’t use the phrase “quantitative easing” (QE) this time, but that is essentially what buying assets is.

The obvious questions are: Has Central Bank buying worked, how long will it go on, and what will the impact be on investors?

Has It Worked?

According to their own report, the Fed alone added $2.9 trillion dollars to their balance sheet in the first three months of the crisis, and the Federal Reserve of New York plans to keep buying $80 billion of assets a week for a while. When they do that, they are buying interest-bearing securities, mainly Treasuries and Mortgage Backed Securities, held by banks and financial institutions and that has two effects.

The first is that it keeps interest rates low as bond yields move inversely to price. If a central bank is buying $80 billion of bonds a week, the chances of those bonds falling in price and rising in interest is reduced. The second is that it adds money to the system. To make the purchases, the Fed creates a credit in the account of the selling bank, basically paying with money that didn’t exist before the purchase was made.

Those two things combined have had one very noticeable effect for investors: It forced the stock market higher. Banks are being handed cash on which they are required seek a return, while at the same time the “safe” return on bonds is being reduced to almost nothing. Little wonder that the market is at record highs.

Asset inflation, however, wasn’t the intended effect of these purchases. The aim was to prop up both the economy and the financial system and there have been mixed results in that regard.

Unemployment is falling in the U.S., and is roughly steady in the E.U., after spiking so suddenly, but are still at extremely elevated levels. It remains to be seen how many of the “temporary” job losses turn out to be permanent. Economic activity, as measured by GDP, is a similar story. Some of the massive losses have been clawed back, but we are still staring at a global recession.

We cannot know for sure what would have happened had the central banks not acted, but common sense suggests the situation would have been a lot worse without the monetary stimulus.

How Long Will It Go On?

Obviously, that is a question that can’t be answered accurately, but it is possible to make an educated guess.

It is worth noting that the monetary stimulus that followed the last recession went on for nearly a decade, and the drop in GDP that we saw in March and April was a lot worse than it was in 2008 and 2009. The expectation is that this time around, the dip will be shorter-lived, but as cases and deaths rise again and we are still without a widely available vaccine or therapy, that is beginning to look more like a hope than a reasonable expectation.

The real problem with this kind of “emergency” action from central banks though, is that it is destined to last a long time, whatever the outcome. If central bank purchases succeed, then that is an obvious reason to continue, while if it fails, the economy and markets couldn’t stand the shock of it stopping.

The Fed, the ECB and other central banks obviously understand this, as they have made it clear in their public pronouncements that this action will go on for what the Fed refers to as “an extended period.”

The Impact on Investors

The impact of all this depends what type of investor you are. If you are a big institution, for example, you are probably doing fine, but if you are already retired and were relying on your retirement savings providing you with interest income, not so much. Still, the most important question is what the impact will be going forward.

In the short-term, it is likely to be positive. As we have seen over the last six months, central banks handing newly minted money to banks and suppressing interest rates doesn’t have to have much, if any, positive impact on the economy for it to push stock prices higher.

Eventually, though, the reckoning has to come.

Either the world’s economies have to catch up with the markets, or the markets will adjust to the economic reality. That is most likely to happen when and if the central banks stop propping them up. But if the Covid numbers continue to get worse and another lockdown looks like the only answer, it could happen even if the free money is still flowing.

As someone who worked in the 1980s interbank forex market, where central banks were always the enemy, it isn’t easy to say this, but I actually feel sorry for central bankers right now. They have been asked to deal with another crisis while still recovering from the last one and were left with no really good options. They did what they had to do, but the question is whether they can manage to wind down and reverse their policies without major disruption.

In the long-term, that remains the biggest unanswered question for central banks.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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