How will major central banks respond to growing financial instability?
The global macroeconomic environment is now in one of the most difficult conditions in generations. Unusual macroeconomic distortions, such as the combination of high inflation and a slowdown in activity, quickly generate episodes of major disruption and stress in the markets. This phenomenon can be observed in most asset classes and countries.
When central banks raise interest rates to combat high inflation, the attractiveness of cash increases relative to other types of assets. This results in a downward trend in the total value of stocks and bonds. In fact, the global asset sell-off that has prevailed throughout the year has intensified in recent months. Year to date, global bonds and stocks are down 22% and 25% respectively.
Development of global shares and bonds
(normalized to 100 in January 2022)
These market fluctuations have caused significant declines in the balanced portfolios of investors accustomed to benefiting from stable positive returns. Year-to-date performance of a traditional asset allocation strategy that divides the portfolio into 60% stocks and 40% bonds shows the worst annual performance in a century, Bank of America says. In other words, this year we are witnessing the largest and fastest process of destruction of financial wealth ever observed. The damage is so extensive that concerns about financial stability are at the center.
The UK monetary authorities had to support the local bond market amid a historic meltdown at the end of September. With long-term yields peaking at over 5% over 20 years, UK bond prices have crashed. This had the effect of driving leveraged pension funds to the brink of insolvency after a wave of margin calls forced them to liquidate their bonds. The Bank of England therefore announced that it would intervene “at any level” to calm the markets. This necessitated large bond purchases.
The British episode has opened the debate about financial instability and the possible need for financial support also from other central banks. In mid-October, US Federal Reserve (Fed) officials spoke with institutional investors, bankers and financiers to assess the risk of a market explosion like the UK in the US. Similar discussions have also taken place in Europe.
The money supply in the US, the Eurozone, the UK and Japan
(M2, billions of dollars)
Sources: Gardens, QNB analysis
It should be noted that these discussions are taking place while major central banks are withdrawing their public budget support from the bond markets. The monetary authorities have abandoned the expansion of public budgets to adopt a more neutral, even restrictive stance. The US Federal Reserve last month began shrinking its balance sheet at a maximum rate of $95 billion per month. This implies a significant reduction in the demand for bonds, leading to higher interest rates for various maturities and a decrease in the money supply.
We estimate that major central banks will probably have to decouple interest rate policy normalization from balance sheet reduction measures. Inflation is too high and this threatens the credibility of the monetary authorities given their inflationary mandate. Previously, most central bankers believed in the need for an alignment of policy tools, that is, policy rates and the public budget should move in the same direction or at least not contradict themselves – easing, neutrality or tightening.
This has resulted in a modus operandi of combining public budget increases with balance sheet stability or reduction rather than balance sheet expansion, which has the effect of increasing money supply and liquidity in the system.
Despite these past practices and beliefs, we are convinced that current conditions require a differentiated approach to the use of monetary policy tools by the main central banks: interest rate policy should be the main tool to combat high inflation, while fiscal policy on the balance sheet should be adapted, in a targeted manner, to possibly support troubled asset markets. This would allow for a more orderly and sustainable monetary policy adjustment process.