Central banks seem more and more inclined to reinvent the role they play in the economy. Their boldness is a result of the fact that, faced with the dramatic turn of events during the 2008 crisis they shattered all taboos which has failed to generate the negative impact foreseen by the economic theory. That only confirmed the lesser of the two evils principle.
A first historic step into the forbidden area was the large-scale rollout of quantitative easing (QE) by the main central banks with the intent of reigning in the 2008 economic and financial downturn. Purchasing the bonds of their own governments and providing limitless liquidity has prevented a complete freeze of the financial system and a global meltdown.
Subsequent attempts at reversing the trend by withdrawing the printed money have been tentative at best due to central bank chairmen’ anxiety over the prospects of a run on the financial market and a stock market crash. Efforts to direct expectations towards a QE reversal, such as that by the Fed chair, Ben Bernanke, in the summer of 2013, adversely impacted financial markets. So much so that the Fed had to step back and acknowledge the fact that politically independent institutions, such as the central banks, ended up being loosing their financial investors related independence.
That was probably the decisive moment when central banks took the critical step towards losing the independence of their monetary policy. Had they done so knowingly? Probably not at the beginning. They entertained hopes that the unorthodox policy could be reversed to reach pre-crisis status quo. The proof lies in the attempts to reverse it which were quickly abandoned by fear of a stock market decline.
As we moved on, the hostage situation central banks found themselves in went from bad to worse. Economic reliance on printed money increased dramatically in the economic crisis triggered by the recent pandemic. The 2008 quantitative easing seems like a warmup compared with the amounts of money thrown at the economy by central banks in 2020. “At the economy“ is a bit of a stretch as a large portion can be found in overly inflated financial or real-estate assets.
And it was financial and real-estate assets price inflation and a flat level of prices of consumer goods that fired central banks’ boldness and imagination. On the one hand a low inflation rate put people’s worries to rest whereas higher prices of financial and real-estate assets suited the financial elites owning them. It made everybody happy, even though the cracks in an increasingly polarized society were increasingly visible with political consequences.
Just as prolonged antibiotic use ends up being ineffective, quantitative easing is about to run out of steam. An even more potent antibiotic is needed. For central banks, that means abandoning the primary goal that they have been religiously upholding throughout the last decades: keeping a low inflation rate in check.
The central bank messages that we have been hearing these days show virtually no concern over inflation whose higher rate they seem willing to tolerate. Another shattered taboo. The main concern is to target or rather pin down interest rates. In other words, interest rates must remain low across all maturities, even as inflation goes up. Interest rates will most likely stay below the inflation rate for quite a while, both in the short term, through low or negative key interest rates, and in the medium and long run, through government bond purchases.
Why? What is the reason behind central banks’ decision to agree to this financial repression of holders of interest-bearing financial instruments? There are at least three reasons for which an interest rate increase is not desired.
Firstly, cheap money is a prerequisite to restarting the economy: on the one hand, loans remain accessible, and on the other hand, central banks hope that by penalising savers they will be encouraged to consume and thus drive economic growth.
Secondly, pandemic public spending has generated a huge amount of debt which is funded by mounting government borrowing. This means that higher interest rates will put more pressure on already significant budget deficits through higher financing costs.
Thirdly, stocks are usually valued based on the net present value of future cash flows. The discount rate is directly influenced by interest rates. The higher the interest rate, the lower the net present value of cash flows. As a result, stock will look overvalued. Consequently, a hike in interest rates will lead to more orders to sell and ultimately to a stock market decline.
Together, these reasons have caused central banks to complete overturn the paradigm according to which they had been operating. Instead of restricting the rise in inflation through flexible interest rate policies, they now restrict interest rate movements through flexible inflation targeting.
Is the National Bank of Romania following the same MO? Not quite. In the past 10-15 years, the NBR’s strategy has run contrary to that of its counterparts in Europe or the developed world: it focused on stable exchange rates at the expense of interest rate which not only once rendered the key interest rate irrelevant. Exchange rate stability was at least as important as a stable inflation rate. This is not by accident given how tied to the euro prices in Romania are.
However, over the medium term, the NBR might prove more lenient towards higher inflation rates than in the past. Its explicit reason lies in its concern to keep the rising current account deficit in check. Increasing the key interest rate in response to higher inflation may cause a real or nominal appreciation of the national currency which drives imports and dampens exports.
As far as capping the interest rate at which the state budget is funded, as I explained on a different occasion, the NBR is not willing to offer a free lunch without some strings attached. It is most likely waiting to see evidence of responsible fiscal policy before helping to finance the deficit cheaply by purchasing government bonds on the secondary market. If the evidence is there, then we may expect that its policy will be brought into line with other central banks.
The conclusion is clear and unforgiving. We are entering an age of sacrificing people’s savings for the sake of financial market and national budgets stability. The good news is that economies will not collapse and may continue to provide jobs and prevent rising social tensions. The bad news is that economic polarization will continue and be a driver of social tensions.
