Test for central bank credibility looms on likely bond losses
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This year’s savage bear market in bonds across the world raises a pressing question in relation to central bank balance sheets. These are greatly enlarged as a result of asset buying, or quantitative easing, in response to the financial crisis and the pandemic.
Yet the US Federal Reserve and other advanced country central banks are horrendously undercapitalised compared with private sector banks. So they are unusually vulnerable to losses on their bond portfolios. They also face unprecedented credit risk on illiquid and dodgy assets acquired through their operations as lenders and market makers of last resort. Should markets worry?
The traditional central banker’s response is: there is no cause for concern. The job of central banks is the pursuit of such noble goals as price stability, not profit maximisation. As Willem Buiter, a former member of the Bank of England’s monetary policy committee has long argued, their balance sheet is anyway a misleading guide to financial strength in that it does not include their most valuable asset: seigniorage, or the profit on manufacturing money.
Any view of central banks’ solvency has to reflect the fact that they can bail themselves out simply by issuing base money — money and commercial bank deposits held at the central bank. So even if the conventional balance sheet is technically insolvent, they would have no difficulty in meeting their liabilities as they fell due.
The supposedly clinching argument for insouciance is that several central banks, including those of Chile, the Czech Republic, Israel and Mexico, have operated without difficulty despite having negative accounting equity in their balance sheets for prolonged periods. They did so because of their credibility on monetary and financial stability at the time.
Whether the same can be said of the big central banks after a protracted episode of ultra-low interest rates is moot. This morally hazardous policy has contributed to unprecedented peacetime levels of debt. Since the financial crisis, the central banks have vastly increased their exposure to market, interest rate and credit risk. And on their central mandate of price stability they have failed dismally to anticipate accelerating inflation. As the BoE’s recent firefighting exercise to address volatility in the gilt market resulting from an unwinding of pension fund investment strategies demonstrated, some have also been slow to identify the whereabouts of excessive leverage in the non-bank financial sector.
Retail investors’ perverse enthusiasm for flaky crypto assets is also a sorry verdict on independent monetary policymaking since it is substantially driven by distrust of central banks’ management of fiat currencies.
The one inescapable fact is that central banks cannot recapitalise themselves in the event of insolvency through seigniorage without generating unacceptably high inflation. The view that they can always print their way out of trouble is simply an illusion. Central bankers anyway do worry about their balance sheets because they are nervous of market perceptions and politicians’ reactions.
In some cases this concern is formalised. The European Central Bank, for example, requires national central banks in the monetary union to avoid prolonged low or negative equity.
It follows from all this that it is not enough for politicians to hold central banks accountable solely for policy. In a recent paper Paul Wessels of De Nederlandsche Bank and Dirk Broeders of Maastricht University argue that adequate capital is necessary to maintain confidence that the central bank is effective in implementing monetary policy and is able to absorb financial risks independently of government.
Establishing a uniform capital adequacy regime for central banks would be impossible. With quasi-fiscal measures such as quantitative easing, where the taxpayer is exposed, the ownership of risk is shared differently between governments and central banks from one country to another.
When compared with the private sector, capital adequacy would also be an imprecise discipline because the incidence and size of financial liabilities arising from last resort lending and market making are inherently unknowable.
For the Fed, capital adequacy is less of a problem than for other central banks. It continues to be the guardian of the world’s pre-eminent reserve currency and markets appear reassured by the Fed’s policy tightening this year. But the severe weakness of central bank balance sheets is sadly symptomatic of how the advanced economies have come to operate with minimal margins of safety.
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