Central banks come to the aid of their states

We are in a new era of mutually-assured reflation, as banks and governments outbid each other to try to combat the great Covid-19 recession.

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  1. Charles Stanley

In recent years, there has been a common assumption in markets that central banks are independent. This was generally thought to be a good thing, because it meant a group of experts free from party politics could make wise judgements about interest rates, credit and the banking systems.

A small shudder went through markets when Donald Trump challenged this idea and started to give the Fed advice through a series of aggressive tweets. Markets ignored the far from glorious role played by the central banks in the banking crash of 2008-9, and sought to interpret the Delphic statements of central bank governors. Many investors realised their powers to control interest rates and general credit levels were going to have a big influence over equity prices. Markets were also generally pleased with central banks all the time they kept rates low and allowed financial assets to appreciate.

If you had put the idea of independence to the Chinese during these years, they would have politely explained they saw the world a bit differently. The People’s Bank of China has always made it explicit it works within the economic policy framework set out by the President, Politburo and Central Committee of the Communist Party. They would regard it as absurd to have an independent bank disagreeing with the national leadership or trying to offset actions of the government.

More like China

No-one is any doubt in China that the central bank has to behave in ways that are compatible with government policy and in conformity with government instructions. What is fascinating about the impact of the pandemic on the advanced countries is it has forced a rapprochement between central Banks and governments. Today the banks work with the Treasuries to offset some of the economic damage being done by anti Covid-19 policies. The banks enjoin the governments to spend and borrow more, and the governments encourage the banks to create more money, make more loans, and keep the cost of government borrowing on the floor.

If we look back, it is clear that at times of crisis or of major disagreement between central banks and governments, governments win. There is no such thing as a truly independent central bank. The nearest we got to it since 1945 was the German Central Bank. It ran a successful low inflation strong developed market policy for many years, which the main political parties supported. When it came to bigger issues, the merger of the Ostmark and the DM to reunite Germany, and the creation of the Euro, the Bundesbank was swept aside. Its good economic advice was binned – and the government made the decisions.

The Fed gave into Mr Trump before the virus hit. Planning to carry on raising rates and cutting back on their large balance sheet it scared the markets and decided to change course. First, it paused the rate rises. Then it paused the balance sheet reduction. Then it started to cut rates, just as the President proposed. When the virus hit, it capitulated, given the change of circumstances, slashing rates to zero and starting up the largest ever quantitative-easing programme.

The markets that thought independent central banks were crucial to success, now think big spending governments working closely with big lending banks are the way through the crisis. In the face of a blizzard of bad news with more poor profits, bankruptcies, capital reconstructions and depressed consumer demand to come, markets go up. The US has days of rioting disrupting business more, so the market goes up. Hong Kong, China and the US intensify their cold war, so the markets go up. Lockdowns are relaxed slowly, with no evidence of any V-shaped economic recovery, but share markets go up. The Fed busily expands its balance sheet by $3 trillion in a couple of months. The ECB announces an increase of another €600bn of bond buying. The Bank of Japan and the Japanese government announce another major stimulus. The Bank of England is expected to increase its quantitative easing soon. Markets await more fiscal expansion from the EU and from the US.

Cash creation dash

In the short-term, inflation falls further and central banks have plenty of scope to continue their dash to create cash. All the time they do so, markets can afford to ignore the news from the real economy. This is a true bubble, with shares getting dearer by the day as prices rise whilst many earnings forecasts fall.

Central bankers will carry on obliging their governments all the time inflation stays low. We are in a new era of mutually-assured reflation, as banks and governments outbid each other to try to combat the great Covid recession. Not a single central bank suggests inflation is a future problem that requires a more independent stance. The figures involved are extreme, but in the short term a huge monetary stimulus is needed to offset some of the damage of anti-pandemic policies. It may soon lead to more people asking why the stimulus boosts the wealth of those rich enough to own financial assets, whilst not stopping many lower paid people becoming unemployed.

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