(Bloomberg) -- The Federal Reserve and other central banks
will eventually discover that breaking up isn’t easy after partnering with
their governments and the financial markets to avert a pandemic-driven
Investors and lawmakers enamored with cheap money may well
balk when monetary authorities try to throttle back their quantitative easing
and other stimulus measures.
“They are increasingly on what I call a no-exit paradigm,”
Allianz SE chief economic adviser and Bloomberg Opinion columnist Mohamed
El-Erian said on a panel discussion last week.
The problem isn’t pressing -- – and in fact is probably one
central bankers would be glad to have if it meant their economies were strong.
Instead, faced with slowing global growth and resurgent infections,
the focus of policy makers at last week’s all-virtual International Monetary
Fund and World Bank meetings was on more support for the world economy, not
less. Central banks are pulling out the stops to do all they can, boosting
financial markets with massive asset purchases and pushing government borrowing
costs to record lows.
Fed Chairman Jerome Powell has repeatedly pressed for more
aid to support to the economy until it’s clearly out of the woods. “The
recovery will be stronger and move faster if monetary policy and fiscal policy
continue to work side by side,” he told business economists on Oct. 6.
The trouble may start after a virus vaccine is approved and
distributed and the U.S. and world economies begin to return to normal. If the
Fed and other central banks are constrained from scaling back emergency
stimulus at that point, the continued flood of liquidity could spur asset
bubbles and even too-rapid inflation.
Rebecca Patterson, director of investment research at
Bridgewater Associates, said she saw some merit to arguments that the U.S.
ultimately will see faster inflation because of continued aggressive fiscal
stimulus. “It’s something investors really haven’t had to think about for the
last few decades,” she told an Oct. 13 Council on Foreign Relations briefing.
“Whether we get it or not, preparing for that risk scenario is pretty
Patterson said that economic policy has entered a new
paradigm, with independent central banks and governments working closely
together to fight the pandemic. Monetary policy makers are buying up government
bonds while fiscal policy practitioners are issuing more of them to finance
mammoth budget deficits. “Fiscal has become the dominant driver,” Patterson
The relationship between the central banks and their
governments is “sort of a honeymoon situation because their interests are
aligned,” former European Central Bank chief economist Peter Praet.
“There is no inflation, so the central banks ask the fiscal
authority to spend more to support aggregate demand,” Praet said on an Oct. 15
panel discussion hosted by the Institute of International Finance. “But when
their interests start to diverge, that’s a very delicate moment.”
Former Fed Governor Randall Kroszner agreed. The big debts
that governments are racking up are “going to make it difficult for central
banks to raise rates when they feel the need to do so” because that will
increase borrowing costs, he said on the same panel as Praet.
The Fed will also find it politically hard to trim its huge
balance sheet after Congress effectively authorized an increase by allocating
money to the Treasury to set up emergency lending facilities with the U.S. central
bank, said Kroszner, now a University of Chicago professor.
The debt deluge may have other consequences. The Treasury
market is now so large that that it may not be able to function smoothly on its
own during times of stress, according to Fed Vice Chair for Supervision Randal
He told a virtual discussion organized by the Hoover
Institution on Oct. 14 that it was an “open question” whether the Fed would
have to keep buying Treasuries to aid the working of the market. The central
bank is currently purchasing about $80 billion of Treasuries a month.
Quarles clarified those remarks the next day, telling the
IIF that he didn’t mean to suggest that he saw a need for a permanent Fed
backstop of the Treasury market.
Former Fed Chair Janet Yellen said she expects the Fed to
provide more guidance on its plans for future asset purchases. But the aim of
the buying would be to hold down interest rates, not fund the federal
“It is not their objective ever to directly try to help the
federal government finance its budget deficit,” Yellen said in a Bloomberg TV
interview Monday. “That would be a very dangerous kind of support to provide.”
Central bank leaders from Europe, Japan and the U.K.
stressed the importance of maintaining the independence of their institutions
at a virtual international banking seminar on Sunday.
“We have to steer clear of what would be regarded in popular
parlance as fiscal dominance,” European Central Bank President Christine
Andrew Bailey, governor of the Bank of England, said the
independence of central banks hasn’t been eroded by their coordination with
governments to help economies through the coronavirus crisis this year.
The bond market is underestimating how strongly the U.S.
economy will rebound, and that may lead to a “mini taper tantrum” next year,
according to John Herrmann at MUFG Securities Americas. In the 2013 taper
tantrum, yields surged after the Fed suggested it would begin scaling back its
El-Erian said that the U.S. central bank has “conditioned
the market to such an extent that every time the Fed tries to step back, the
market forces them back in” by selling off and tightening financial conditions.
Former Bank of England policy maker Paul Tucker agreed that
the financial markets have come to expect periodic support from central banks
after years in which monetary policy makers effectively delivered just that.
“I wait, longing for a central banker to do for financial
stability what Paul Volcker did for inflation, which is to break that
psychology that you, the capitalist markets, are actually utterly dependent on
the Federal Reserve and other central banks, propping up prices come what may,”
(Adds Yellen comments in 17th and 18th paragraphs)
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