Central bankers are rarely out of the media. When not changing rates or announcing new infusions, they are jawboning markets and pontificating on economic conditions.
This prominence is recent. Building on the credibility of his predecessor Paul Volcker in controlling inflation, Alan Greenspan of the US Federal Reserve intervened after the October 1987 stock market crash despite little evidence of any threat to economic activity. The Bank of Japan interceded to deal with the aftermath of the 1990 collapse of the bubble economy.
The rulebook expanded after the 2001 dot-com problems and the 2007/8 financial crisis. The staple was interest rates. When they approached zero, central banks innovated with negative rates and implemented quantitative easing (QE), purchasing securities, government bonds, but later including mortgage-backed securities, corporate bonds and shares, using newly created reserves.
Central banks implemented yield curve control (YCC) to target specific rates. Policymakers introduced financing arrangements to provide funds to banks to bolster liquidity and also on-lend to clients. Critics joked that central bankers would deploy these tools to even combat an alien invasion.
An analysis of these policies is unflattering. The effects on economic activity were inconclusive. Low rates and abundant money did not always convince households, some already heavily indebted, to take out new loans. Businesses proved reluctant to borrow to invest when demand was low.
Another objective was to create inflation to encourage spending to avoid higher future prices, reduce debt in real terms by decreasing purchasing power and, most importantly, avoid deflation where falling incomes and taxes would make debt servicing difficult.
But labour market changes—particularly the shift away from permanent work and reduced wage bargaining power in part due to reduced unionisation and industrial overcapacity—especially in China, kept prices in check. Inflation remained stubbornly low until the supply shock of the pandemic and military conflicts. The use of low rates to devalue the currency to increase export competitiveness floundered because every country followed similar strategies.
The policies were more successful in reducing the risk of corporate bankruptcy by lowering debt servicing costs. It helped banks recapitalise by using cheap funding to invest in higher-yielding government bonds to increase earnings. It helped governments raise money by borrowing de facto from its central bank to finance spending.
The real effect was on asset markets. As values reflect future cash flows discounted back to the present, an upward shift in prices was natural. Near zero rates meant the adjustment was exaggerated.
Low rates drove a search for higher returns, causing investors to overpay for long-duration bonds, high- and low-quality corporate debt, equities and real estate. It enticed investment in illiquid assets like infrastructure, private debt and equity, and venture or start-up capital. It encouraged increasing leverage to enhance available returns.
Intervention by the authorities and their underwriting of risk-taking suppressed volatility. This encouraged investors to sell options to enhance their returns through the premiums received. Asset managers employed investment strategies, often camouflaged under innocent names such as ‘risk parity’. There were pernicious feedback loops, with falling returns leading to more risk-taking, compressing yields and margins boosting prices further.
These developments have significant costs. First, the policies encouraged rapid growth in private and public debt. It facilitated fiscal indiscipline of governments who ran large budget deficits. An economic model of consumption and investment using borrowed funds became entrenched.
Second, capital was misallocated. Easy money allowed the survival of ‘zombie’ enterprises—indebted businesses that generated sufficient cash to cover costs and loan interest but not sufficient to invest in operations or repay the debt itself.
Third, asset prices became detached from intrinsic values, creating the constant spectre of financial instability. Rising prices for financial assets favoured high-income, wealthy cohorts exacerbating inequality.
Fourth, it fundamentally altered financial markets. Abundant cash, low rates and YCC artificially reduced risk. The US Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank hold around 16, 53, 27, and 30 percent of outstanding government debt. The Bank of Japan holds around 7 percent of the stock market. The Swiss National Bank has a share portfolio (consisting mainly of US stocks) of around $200 billion (around 20 percent of GDP). This overhang and potential central bank activity distorts prices and liquidity.
Fifth, speculation and risk-taking are now underwritten by the ‘Greenspan Put’. Investors assume in case of problems, central banks will step in to ensure survival of banks and institutions deemed ‘too big to fail’.
Sixth, the ability to normalise policy settings—increasing rates or selling asset holdings—is restricted. Higher interest costs would increase the risk of financial distress for the growing numbers of over-indebted borrowers. Governments with high debt levels face larger financing expenses and must raise taxes or cut spending elsewhere. This, combined with falling collateral values, threatens lenders. The current pressure on central banks to cut rates reflects, in part, these pressures.
Finally, the policies generated toxic interest rate exposures that damaged balance sheets. QE created an asset liability mismatch as central banks purchased longer maturity securities with modest fixed rate coupons, funding them with reserves paying short-term rates. When rates rose in 2021 to counter inflationary pressures, the value of these bonds fell sharply. Central banks now have large unrealised losses that would be crystallised on sale. Their income is affected by the higher interest paid on reserves, below the earnings on the bonds.
Major central banks are now nursing large market-to-market losses and some have negative shareholder’s funds—not ideal for the guarantor of the financial system. The mismatch affected commercial banks, who used the liquidity provided by central banks similarly, investing in long-dated assets to boost income. This was behind the problems of US regional banks in 2023.
History will not be kind to central bankers fixated on financial economy and who created serial speculative booms to sustain the illusion of prosperity. It will also be critical of governments unwilling to address weaknesses, who deflected shifting hard policymaking to independent, unelected and largely unaccountable central banks.
(Views are personal.)
Satyajit Das
Former banker and author