April 10, 2019/Fitch Ratings
Recent challenges to central bank independence in a number of countries mark only the beginning of an extended macro policy debate that is likely to play out in the years ahead, especially where economic growth is slowing.
In emerging and developed markets alike, strong central bank balance sheets (generating seigniorage profits) compared with those of governments, combined with well-earned central bank policy credibility in many jurisdictions, are attracting the attention of fiscal policymakers. Investors would be wise to consider the potential implications of mounting political pressures for greater contributions from monetary policy to support economic growth, possibly by unconventional means.
Reinforced central bank balance sheets in emerging markets can be traced back to the 1997 Asian financial crisis, when currency and maturity mismatches between countries’ external liabilities and domestic assets overwhelmed central banks’ foreign currency reserves, causing sharp depreciations and widespread financial distress. The subsequent accumulation of foreign reserves was one of many changes in the Asian policy landscape, and a lesson of the crisis that emerging market central banks elsewhere took to heart. Excluding China, emerging market foreign reserves have increased nearly nine fold since 1996, more than double the expansion of GDP (converted to US dollars at market exchange rates).
In developed markets, it was the 2008 global financial crisis that set central banks apart. Monetary authorities in several countries enacted emergency measures to cope immediately with financial sector dislocation and then to support economic activity where fiscal space was perceived to be limited. A critical point to reflect upon is that central banks were accepted as credible economic and financial market stabilizers in large part due to previous policy successes in their most commonly shared core mandate of delivering low and stable inflation.
A combination of factors that looks set to intensify points to central banks being called upon again to provide at least counter-cyclical economic support, and possibly more. Growth is slowing in most major economies and many governments’ debt levels have not been meaningfully reduced, if at all, during the recent strong growth period. Fiscal space is again limited, and — critically — central banks, having contributed to lifting emerging and developed markets out of crises in the last two decades, are being increasingly viewed by governments as ripe for a broadening of their remit beyond controlling inflation.
In the United States there is growing support for the notion that, with the dollar being the preeminent global reserve currency and Treasury securities concomitantly the world’s most sought-after risk-free asset, there is an opportunity to fund increased government spending with the creation of money, for which there is essentially unlimited demand. This would support economic growth while setting aside the budget constraint and avoiding inflation, at least as long as the economy operates below potential. In pulling together disparate strands of what is known as Modern Monetary Theory (MMT), supplemented by real-world examples — specifically the Bank of Japan purchasing vast quantities of government debt while keeping interest rates near zero and incurring little inflation — proponents of these ideas present a seductively simple and appealing policy prescription.
There is one overriding problem with the MMT discussion in the US. As many governments in other countries have previously discovered, assuming unwavering demand for a currency undergoing a large or sustained increase in supply goes against the basic tenets of price stability and rational investor choice. Adding to the supply of money must eventually diminish the value of that already in circulation, relative to both other monies (currency depreciation) and goods and services (inflation). Japan’s experience is unlikely to be a reliable guide to the consequences of enacting similar policies in other countries. Japan is unique in having battled pernicious deflation for much of the last two decades, often attributed to a sharp currency appreciation following the Plaza Accord of the mid-1980s and the bursting of a real estate bubble a few years later.
Proponents of MMT in the US have explicitly cited the advantages of dollar as the world’s reserve currency and Treasuries as the preferred global risk-free asset as reasons why the policy can succeed, and in doing so have helpfully identified what would also be put at risk. The position of the dollar as the world’s reserve currency is incongruous with an explicit policy of limitless dollar supply. Similarly, the risk-free status of Treasuries is incompatible with an overt policy of either never repaying them or repaying them with a much depreciated currency.
Central banking with fiat money is based on confidence above all else. Confidence, in turn, relies on robust balance sheets and prudence in managing all aspects of central bank finances and areas of policy responsibility. The current combination in some countries of balance sheets that are strong for central banks and weak for governments is worrying where fiscal policymakers are looking to central banks as part of their solution. The risk is central bank balance sheets are then weakened too, and confidence ebbs. The benefits of lower inflation could be jeopardized, and, in the case of the US, the specific advantages of hosting the world’s reserve currency and risk-free asset could be diminished.
For investors, the recently reliable assumption that historically low inflation and real interest rates are here to stay might need to be revisited. Central banks may have the upper hand in terms of policy credibility in the debate that has already started, but governments more often have the legal authority to impose their will. While the US is a considerable distance from adopting MMT as envisioned by its supporters, pressures on the central bank there and elsewhere will be growing in the period ahead.