Central banks have an attack of prudence

The world’s central banks rescued markets from despair in the third week of March. However, they still need to provide guidance on how they are going to deal with the recovery.

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  1. Charles Stanley

In March, confidence had been shot to pieces by the lockdowns of so many economies worldwide. Rumours stalked the dealing rooms of terrors to come, with fears of bankruptcies, scarred economies and squeezed liquidity.

Led by the Fed, the main Central Banks injected huge sums. They created money on an unprecedented scale to buy government bonds and other financial assets. Their actions triggered a reversal in the short and savage bear market – and led to a sustained recovery in the prices of many assets.

The Fed's own balance sheet ballooned from $4.158 trillion in February to more than $7 trillion by June. The ECB increased its assets and liabilities from €4.68 trillion in February to €6.748 trillion by September. The Bank of England and the Bank of Japan were also ready to boost their interventions in financial markets. Money growth as a result rocketed. The US M2 money supply grew by 18% between February and June. UK M3 growth rose by 10% between January and June. The annualised growth rates were record breakers. The Fed made dollars available to the rest of the world to ease the shortage of the global reserve currency that had developed.

Dear prudence?

Over the summer it appears the central banks suffered an attack of prudence. Investors still had ringing in their ears the promises of overwhelming stimulus, with the Fed saying there were no limits on how much money it would create. They would do whatever it took to stabilise markets and to give recovery a chance from the dark days of lockdown.

Meanwhile, there was a stealthy resumption of caution. The Fed's balance sheet fell by more than $200bn between June 8th and August 10th. The Bank of England reduced its assets slightly by early September. Money growth decelerated rapidly. This provided the background for the sell-off in the market-leading US big tech stocks recently and left markets wondering how firm future central bank support would prove.

This week the tussle between the bulls and the bears will resume around interpretations of the Fed's statements following their meeting. Many are expecting the Fed to lay out some more dovish rhetoric. After all the US economy is still struggling with social distancing, with the aftereffects of the big shakeout of jobs caused by the lockdowns, the damage to the western states by forest fires and the impact of the low oil price on the successful oil and gas sector. The Fed will have noted recent jitters in equity markets and seen the indigestion in the government bond market brought on by the huge scale of government borrowing.

The Fed has set up the opportunity for further easing by its recently revised statement of policy. As expected, it has said in future it will seek to correct for periods of undershooting the 2% inflation target by allowing a compensatory overshoot. We have just lived through a long period of lower inflation, and inflation expectations have been dented by the pandemic recession, though they have recovered a bit on the back of Fed action and GDP revival from the lows. Surely, the bulls reason, the Fed must have to announce something more? Perhaps they could announce a higher target for bond purchases than they have been achieving recently. Perhaps they could be more explicit about yield curve control, binding themselves into more energetic buying of bonds?

Inflation threatens again

The bears think maybe the Fed is privately pleased to have weaned markets off such extraordinary measures as we witnessed in March to May. Traditional Central bankers prefer to err on the side of caution over inflation. There may be a reluctance to being too flashy in policy ahead of a bitterly contested and important Presidential election. The Fed itself has spent a year studying where it went wrong prior to the pandemic, and still seems a bit lost over why markets fell and commentators objected so strongly to its modest efforts to withdraw QE and raise rates just before the virus arrived. We do know it desperately wanted to get rates up and its balance sheet down before Covid-19 struck.

The ECB has also been a bit at sea under Christine Lagarde as its new head. She made an early and costly mistake by venturing that the Bank was not concerned to control the spread between the cost of German and Italian debt in its system and soon had to announce a large QE programme with the intention of keeping all government bond rates in the zone down. More recently, she has implied she is relaxed about the level of the Euro, while the southern part of the zone is keen to see some devaluation. As the dollar falls so the Eurozone experiences additional monetary tightening.

It is important this week to see if these Banks can give us more clarity, and if they start to lead events. Their task is not easy. Some of them want governments to do more through fiscal policy, but that will require the central banks to do more to keep the cost of government borrowing down despite the issue calendar. Some think they should get on with doing more, emboldened by more economies apparently moving closer to Japan's experience of low inflation combined with easy money and large state deficits. More money is needed to sustain asset prices against a poor economic outlook. Otherwise, bulls will be left praying harder for a vaccine that works at pace and on an unprecedented scale of the rollout.

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