The central bank exacerbated the problem by purchasing government bonds funded by overnight reserves, shortening the maturity of funding on the combined balance sheet of the government and the central bank. This means that as interest rates rise, government finances are likely to become more problematic, especially in low-growth countries with high levels of debt. Fiscal problems are already weighing on the policies of some central banks, with the European Central Bank, for example, calling for monetary policy to become “fragmented” (where the bond yields of fiscally weaker countries exceed those of stronger countries). ). At the very least, central banks should have recognized the changing nature of politics, which makes unrestricted spending more likely in response to shocks, even if they were not expecting them. For this reason, it is possible that they have become more concerned about suppressing long-term interest rates and supporting policy rates of “long-term low interest rates.”
The private sector has also stepped up, both at the household level (think Australia, Canada and Sweden) and at the corporate level. But there is also a new and often overlooked concern: reliance on liquidity. When the Fed injected reserves during quantitative easing, commercial banks financed their reserves primarily with large demand deposits, effectively shortening the maturities of their debt. Moreover, they make all kinds of liquidity commitments to the private sector in order to extract fees from the large amount of low-yielding reserves on their balance sheets. i.e. committed lines of credit, margin support for speculative positions, etc. (think about how you do that). Many banks were trapped in speculative positions by Archegos, a fraudulent fund). The problem is that it is difficult for commercial banks to unwind these commitments quickly as central banks shrink their balance sheets. The private sector has become even more dependent on central banks for continued liquidity. We first got a glimpse of this in the UK pensions mess in October 2022, but a combination of central bank intervention and the government’s rollback of extravagant spending plans spread the mess. However, the episode hinted at the liquidity-dependent private sector potentially impacting the central bank’s plans to shrink its balance sheet to reduce monetary easing.
High asset prices, high private leverage, and reliance on liquidity suggest that central banks may face financial domination, with monetary policy focusing on financial conditions such as sharp declines in financial asset prices rather than inflation. It will correspond to The Fed’s task of lifting monetary accommodation is made more difficult by current private sector expectations that the Fed will be forced to cut policy rates early, whether or not it intends to be dominated. . Without these private sector expectations, the situation will remain tough for a longer period of time than the government would like. And that means a bigger negative impact on global operations. This also means that when asset prices reach a new equilibrium, households, pension funds and insurance companies will all experience significant losses, but these companies will often benefit from higher prices. means not. The bureaucratically controlled, the unsophisticated, and the relatively poor are drawn to the tail end of the asset price boom, producing problematic distributional outcomes for which central banks bear some responsibility.
Finally, one area where reserve central bank policies have been effective but have very limited influence over their actions is external spillovers. Clearly, the policies of core reserve countries influence their periphery through capital flows and exchange rate fluctuations. Peripheral countries must respond, regardless of whether their policy actions are appropriate to domestic conditions, and failure to do so will result in long-term consequences such as soaring asset prices, excessive borrowing, and ultimately a debt crisis. be affected.
So while central banks can claim to have been surprised by recent events, they have served to constrain their policy space. Asymmetric and unconventional policies, ostensibly aimed at dealing with policy interest rates touching the floor, not only make it difficult to fight inflation, but also create various imbalances that create new problems for the world. caused. Central banks are not innocent bystanders, and the fact that their role in causing the global financial crisis was underemphasized has given them more freedom to act, resulting in new vulnerabilities. is occurring.
Excerpt from Monetary policy and its unintended consequences Written by Raghuram G. Rajan. Reprinted with permission of MIT Press. Copyright 2023.
Raghuram G. Rajan is the Chicago Booth Catherine Dusaku Miller Distinguished Professor of Finance and served as the 23rd Governor of the Reserve Bank of India from 2013 to 2016.
