Jaisal Pastakia, investment manager at Heartwood Investment Management comments on the changing role of Central Banks ahead of the ECB’s monetary policy meeting.
Mervyn King once stated that central banks should aspire to be boring. Since the 2008 financial crisis, central banks in the US, Europe and Japan have all turned that aspiration on its head, slashing interest rates and pumping huge amounts of liquidity into the financial system, all participants in the Great Central Bank Experiment.
As central banks started out on that journey, the damaging consequences of that experiment were thought to be around ‘profligate’ policies leading to undue higher inflation. How misguided that analysis seems today. Over the last week we have seen the downward drift of inflation data across all major economies, complicated by an oil price falling more than 50% since July 2014. Avoiding a negative spiral of low growth and low inflation remains the order of the day, especially if you’re a central banker in the eurozone or Japan.
Inevitably that requires less of the boring, and more of the bolder, courageous decisions. With all focus on the European Central Bank (ECB) this week, the market fully expects the announcement of sovereign bond purchases. The disappointment will be palpable if no action is taken. It is difficult to predict the potential size, composition and pace of a sovereign quantitative easing (QE) programme, although ECB policymaker Benoît Coeuré’s observation “to be efficient it would have to be big” provides some sense of what to expect.
Whether a sovereign QE programme works in the eurozone is open to question, given the political complexities around liability sharing and how sovereign bond purchases are allocated. For example, how will the ECB approach purchases of Greek government debt with a potential Syriza administration? The Federal Reserve’s programme was more straightforward in a homogenous marketplace. Furthermore, the ECB is very clear that its explicit mandate is limited to maintaining price stability. According to policymakers, policies designed to stimulate growth are the responsibility of governments through structural reforms and fiscal policy, where progress among countries has been slow and uneven.
As in the US, the ECB will be hoping that sovereign bond purchases will have an impact on lowering longer term rates, especially in the periphery eurozone, where the hope is that the banks will pass any rate reductions on to households and corporates. The ECB will also be trying to encourage banks to reallocate assets away from sovereign bond purchases into higher risk assets, with a view to stimulating the growth of the euro credit market.
But it is not just the impact of QE – positive or negative – on the eurozone that needs to be considered. There are also the unintended and unknown consequences across global markets, especially in foreign exchange. This was no better demonstrated by the Swiss National Bank’s (SNB) action to remove the currency peg against the euro; another economy battling against deflation. With the prospect of sovereign QE in the eurozone and the likely impact of significant euro inflows into Switzerland, the SNB gave up trying to defend its currency when foreign exchange reserves already amount to 80% of national GDP. In turn, Polish and Hungarian banks hold external liabilities denominated in the Swiss franc which may add to further pressures on those economies.
The ECB has a huge task this week to restore confidence and trust in financial markets. The ECB’s record has been commendable in this regard, but the stakes are getting higher. President Draghi, President of the ECB, probably aspires to be boring; markets hope that he will be rather more interesting.