The current crisis has demonstrated the huge influence wielded by central banks. But it has also revealed how some of that influence has started to wane.
To understand why, it’s helpful to think about the two critical functions performed by central banks during economic and financial crises. The first is to provide monetary stimulus to support aggregate demand and thus economic activity. The second is to act as a lender of last resort in order to avert a liquidity crisis.
Admittedly, there’s a large grey area that sits between these two roles. For example, when do asset purchases by a central bank constitute monetary stimulus and when do they reflect that central bank acting as lender of last resort? There are also feedback loops from one to the other. If the central bank provides liquidity as a lender of last resort, it will tend to ease financial conditions and therefore provide monetary stimulus.
Nonetheless, this is a useful framework for thinking about the response of central banks to the current crisis. In developed economies, there have been relatively few policy measures that can be deemed pure monetary stimulus. The Fed and the Bank of England have cut interest rates and some central bank asset purchase programmes fall in the grey area between monetary stimulus and lender of last resort. But the ability of central banks to loosen policy in order to support aggregate demand has been limited by the low level of bond yields across the curve, as well as growing scepticism about the benefits of cutting interest rates into negative territory.
Accordingly, most actions by developed market central banks over the past month or so have tended to reflect their role as lenders of last resort. In the US, this has included the Fed’s corporate credit facility and its money market mutual fund facility, and in the euro-zone this has included the ECB’s pandemic longer-term refinancing operations (PELTROs). (For a good illustration of where these various facilities sit on the spectrum between monetary stimulus and lender of last resort, see our latest Global Central Bank Watch.)
There were early difficulties in getting some of these schemes off the ground, but in general they have been effective. Strains in funding markets have eased, spreads have narrowed and the dollar squeeze that threatened to destabilise the global financial system in the last week of March had ended by early April.
Central banks’ role as lender of last resort therefore means that they continue to wield huge power in times of economic and financial crisis. This is particularly true of the euro-zone, where a reluctance to entertain even small moves towards fiscal union or the mutualisation of sovereign debt means that the ECB still has more work to do. One legacy of this crisis is likely to be that it ends up owning a much larger chunk of the euro-zone’s sovereign bond market. This is likely to expose political faultlines in the single currency area that will cast a shadow over its future long after the virus has faded.
But the events of the past month or so have also demonstrated how central banks are now operating at the limits of what they can do to support aggregate demand. Another consequence of the crisis could therefore be that we’re entering an era of more active fiscal policy. And as central bank asset purchases continue to blur the line between fiscal and monetary policy, this could yet mean that deficit monetisation is the next taboo to be broken.
In case you missed it:
- Our Senior Markets Economist, Oliver Jones, investigates what a rise in financial repression would mean for asset allocators.
- Our Chief US Economist, Paul Ashworth, argues that the Fed will remain reluctant to embrace negative interest rates.
- Our China team looks ahead to next week’s meeting of the National People’s Congress meeting in Beijing.