BALANCE-SHEET RISK

The Central Banks’ House of Cards

house-of-cards-fotolia
Nobody sneeze. Source: Fotolia

“Give me control of a nation’s money and I care not who makes its laws.” More than two centuries ago, the founder of the Rothschild dynasty, Mayer Amschel Rothschild, already knew the enormous power of central banks. In recent years, the large central banks of the western world have exploited their power more radically than ever before in their long history. Instead of, as previously, limiting themselves to influencing short-term interest rates, they have deployed trillion-dollar bond purchases, negative interest rates and other instruments to push down interest rates on every asset class on the markets, and drive asset prices to dizzying heights.

Now the West faces a sea change. This Thursday, the governing council of the European Central Bank, or ECB, will meet in Frankfurt, to discuss how they can gradually reverse course after several years of expansionist monetary policy. Likewise, the American central bank, the Federal Reserve, or Fed, will this month begin to slowly shrink its balance sheet, by now inflated to $4.5 trillion.

It is an extraordinarily risky turnaround. In recent years, large quantities of cheap central bank money has flooded the finance markets to such a degree that investors feel cozy and warm, like in a well-heated bath. But what happens when the plug is pulled?

The market magic performed by ECB president Mario Draghi and other magicians in recent years cannot be easily undone.

No one can really know the answer to this. But one thing is clear: the market magic performed by ECB president Mario Draghi and other magicians in recent years cannot be easily undone. It would be an illusion to believe that withdrawing from radical monetary policy can be just as quick and painless as entering into it.

What are the facts? For years, the ECB has been holding base rates at zero percent and bank deposit rates at minus 0.4 percent. They have bought more than €2 trillion, around $2.38 trillion, of government and corporate bonds. These three measures have driven investors out of low-risk bond markets and into riskier investments: property, equities, bonds from firms with poor credit ratings. As a result, the price of these assets has been driven up vertiginously, as has the price of the government and corporate bonds directly bought by the ECB. Thanks to this cheap money, the limping economies of the euro zone have, to some degree, been jolted back into action. According to Mr. Draghi and the markets’ other masters of ceremonies, bond buying has been a great help to the financial world and to the economy as a whole. But what happens when monetary-policy stimulus is withdrawn? Is the effect meant to suddenly switch into neutral, rather than negative?

That goes against all logic, and it is the unspoken reason why the beginning of withdrawal will be far more cautious than many think. Bond buying will be rolled back slowly and will not end before the end of next year. But that means the ECB will continue to supply the markets with cheap money until the end of 2018, albeit in slightly smaller doses. Afterwards, the ECB balance sheet will not be one cent smaller. On the contrary, it will reach an all-time-record high, at around €4.5 trillion.

A real change of direction will only take place when the ECB begins to stop rolling over maturing bonds which it currently holds. This is a step the Fed will soon take – a full three years after the end of their own bond-buying program. And even after this, the ECB will take years to bring down their balance sheet to pre-crisis levels. This is because it will struggle to find buyers for all the state bonds it sucked up in recent years, not least because of their low yields. It will have to hold most of these bonds until maturity, and that could take some time: for example, the average maturity for Italian government bonds held by the ECB is no less than 8.6 years.

It will be the beginning of 2019 before higher interest rates are on the agenda. Even this ultra-slow withdrawal from ultra-low monetary policy will be something like a bomb disposal operation, say analysts. There is an enormous risk of something going wrong and prompting extreme market reactions. When interest rates begin to rise, or perhaps before, the risk increases of snuffing out economic growth, as has often happened in phases of monetary tightening. Debt default could follow.

The bitter truth is this: like investment bankers before the crisis, central bankers don’t know how to hold up their giant house of cards, even if they maintain a well-polished façade to the outside world.

 

To contact the author: d.schaefer@handelsblatt.com

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