Central banks need to tone down support

After the deluge of loose monetary policy during the global financial crisis of 2007-9, there is a seeming flood of central-bank intervention in the financial markets, especially in the mature economies.

Already, the mavens are thinking aloud about the expanding role of central banks since the crisis, and pointedly asking, what are the limits? A recent paper on policy, at the Bank for International Settlements, notes the renewed mandate of late for supervision and financial stability on the part of central banks.

But it emphasises that extended support of the latter in bond markets, those for currencies and enhanced credit support generally, all need to be wound down. And sooner, the better, it adds.
    
Now in the so-called emerging market economies and especially here in India, the central bank has traditionally had a broad mandate for prudential bank and non-bank supervision, complete with a ‘wide range of activities’ such as managing government debt, the exchange rate and developing local-currency bond markets.

However, in the last two decades, a ‘broad consensus’ arose in the more mature economies that price stability, read low and stable inflation, ought to be the main — if not the exclusive — goal of central banking.
    
Additionally, the consensus view was that monetary policy worked through interest rates and not through ‘any direct effect of monetary aggregates.’ Further, what’s implied was that the objective of price stability was best served when the monetary authority focused on one instrument alone, namely the policy interest rate.

The reasoning was that bond yields — note that government, corporate, municipal bonds etc form the bedrock of the market system — moved with changing expectations of future policy interest rates.

And that the yields also factored in changing cash flows from equities and real estate, the main asset classes. Hence the assumption that monetary policy need only influence ‘current and future expected short-term interest rates.’ The idea being that long-term rates and asset prices would adjust more or less in a predictable fashion, to changes in the short-term rates.
    
There was the potential for bank runs, to be sure, given that commercial banks accept short-term deposits as liabilities, and provide longer-term loans as assets. But such ‘microprudential’ tools as higher capital requirements were seen as quite enough to avoid systemic rigidities.

Post-crisis, with billions of dollar worth of mortgage-backed securities in the US turning out to be quite worthless, following large-scale default on housing loans and weak property prices, there was unprecedented intervention in financial markets by leading central banks.

It began with conventional monetary easing, followed by policy interest rates approaching the ‘zero bound,’ massive liquidity provision to banks on extraordinary terms and longer maturities, and outright bond purchases to ease severe financing conditions on the ground. Without active bond markets, the monetary policy transmission process itself would have been thoroughly hampered.
    
Meanwhile, there have been large sell-off of forex reserves in emerging markets like Brazil, Korea, Mexico, Poland and Russia, with large corporate and banking sector exposure to exchange rate depreciation.

It has led to concerned central banks extending forex loans to banks and corporates. The result is that central bank balance sheets are rather over-extended in several emerging markets, and are twice their precrisis levels in the advanced economies. Hence the need to unwind financial intervention, underlines the paper.
    
In the post-crisis environment, central banks are now expected to ensure macroeconomic stability in a much broader sense than price stability, including policy discourage build-up of financial imbalances and asset prices by way of credit booms.

There’s renewed stress on microprudential norms, including of non-bank financial institutions. The regulatory moves need to be welcomed on a permanent basis, avers the paper.

However, central banks cannot substitute for the market in setting asset prices, and ought to wind down financial interventions, and sooner rather than later, concludes the paper.