by Ignacio de la Torre
A few months ago, the general scenario that guided economic forecasts was based on the fact, that central banks were increasing their balance sheets instead of diminishing them. Recently, the ECB stopped additional purchases of bonds, leaving the BOJ as the only significant central bank pursuing an expansion of its balance sheet, an expansion that was greatly offset by the reduction that the FED had been carrying out since the end of 2018. For the first time since the financial crisis, one could observe a net aggregated reduction of central banks’ balance sheets.
During the last months, we have seen profound changes in the pillars of the global economy, changes that explain the shift away from the current global scenario already mentioned (towards the new normal). In the light of recent events, the ECB decided to start purchasing additional bonds again, €20,000 million in volume per month. This decision has been criticized by many central bankers, mainly from Northern European countries (or northern European governors of the ECB). However, the major part of the ECB Governance Board is of the belief that more monetary stimulus is necessary to tackle current economic weakness, just in the same way as in a deflationary scenario. The BCE ECB has requested countries, with room to implement ad-hoc fiscal policy, to do so, although, that goes beyond the monetary policy mandate of the ECB. Due to the fact that the ECB has not reached its 2% target inflation rate for many years, it is likely, that the rhythm at which the additional bonds are purchased remains stable in the foreseeable future.
At the same time, the most important central bank in the world, the FED, has also foregone a deep change. During 2018 and a great part of 2019, it was pursuing a dual approach of restrictive monetary policy: not only did it increase the federal funds rate up to 2,25%, but also went on decreasing its balance sheet by $40,000 million per month. The two measures combined have resulted in an equivalent increase in interest rates of more than 6%, which is going to contribute to a deceleration of the US economy with delayed effects, to be experienced during the second half of 2019, and with risk of a technical recession in 2020. In the event of a technical recession, the political consequences could be highly relevant, taking into account that US elections are scheduled for November 2020. This fact is likely to explain the great emphasis that US President Donald Trump has placed on its requests to the FED to change its monetary policy, a behavior that opposes generally accepted behavior that a President ought not to be involved in a country’s monetary policy.
As the uncertainty, driven by the US/China Tradewar, impacting global economic growth, one could notice a strange phenomenon: historically, US economy had been the main contributor to global economic growth and the trigger for spreading economic trends throughout the financial markets. Nowadays, however, it seems that global economic weakness is slowing economic growth in the US. As a consequence, the FED stopped reducing its balance sheet in the second trimester of 2019, and just initiated a process for decreasing interest rates in the third trimester. Since then, strong tensions have been observed in the US money market (REPOs). Theoretically, the excess liquidity deposited in commercial banks’ reserves should be put in circulation within the money market, so that match the federal funds rate imposed by the FED. However, three weeks ago, the overnight interest rates increased by almost up to 10%. What happened? The answer is that tight liquidity requirements for banks, induced in the aftermath of the financial crisis, make banks unable to lend to each other as it was expected. Consequently, the overnight interest rates peaked, as we have already mentioned (), suggesting that monetary policy would no longer be generating a transmitter effect throughout the economy.
In order to tackle these challenges, the FED carried out different, urgent interventions in the overnight lending market, and very recently, the FED also announced it would be expanding its balance sheet again, by means of purchasing commercial banknotes, at a volume of $60,000 million per month. Subsequently, these actions will bring about more excess reserves into the US banks’ balance sheets. It is expected that if these excesses outweigh the regulatory requirements, then tensions within the money market will start to vanish.
In a nutshell, Europe and USA have moved from a situation, where central banks were reducing their balance sheets at a pace of $40,000 per month, to a new one where they increase their balance sheets at a pace higher than $80,000 million per month (while the Japanese keep pouring $30,000 million per month in to the financial system). Is it considered money? It depends whether money is defined as the balance sheet of the central banks (then, yes) or it is defined as an increase of money in circulation. Considering the latter, the expansion of central banks’ assets does not necessarily trigger an increase in the amount of money in circulation, as we all have learned during the crisis and throughout this article.
The consequences of these unparalleled monetary actions are unpredictable. What we certainly know, notwithstanding, as Robert Farrell said, is that “new eras don’t exist…excesses are never ever-lasting”.