Central banks’ coronavirus bailouts are distorting the market, but do they even realise it?

By hoovering up debt, central banks are becoming major market players. In capping bank dividends, they force prudent investors into a frothy market. Does anyone still believe that the central banks know what they are doing?

Reading Time:3 minutes

Federal Reserve chairman Jerome Powell greets Treasury Secretary Steven Mnuchin after testifying on the Fed’s pandemic response on June 30. The Fed has added an unprecedented US$3 trillion to its balance sheet so far this year. Photo: EPA-EFE

Published: 3:30am, 1 Aug 2020Updated: 9:08pm, 13 Oct 2020

When the US Federal Reserve announced on last Wednesday that it was “committed to using its full range of tools to support the US economy in this challenging time”, the market read it as the Fed would do whatever it takes to support the United States in its worst pandemic and economic recession since the 1930s.

Since the beginning of this year, the Fed has expanded its balance sheet by an unprecedented US$3 trillion, to just under US$7 trillion, by buying US Treasuries, mortgage securities and commercial debt. Including the European Central Bank, Bank of Japan and People’s Bank of China, the world’s top four central banks have added about US$6 trillion this year to their balance sheets, reaching US$25.2 trillion, or 28.7 per cent of last year’s global gross domestic product. That is serious money – and your money.

What are the effects of such central bank action? First, inflation remains low because there is much excess capacity due to the coronavirus lockdowns. Second, stock market prices are near record highs and have mostly recovered from the March dip because of excessive market liquidity. Third, interest rates are near zero or negative, which removes their pricing or resource allocation role. Interest rates are kept low when the central bank is willing to supply liquidity to keep it so.

Central banks are now the largest buyers of government debt and commercial and mortgage paper – becoming not a lender of last resort but a major player in the market. Because central banks will do whatever it takes, investors no longer look at interest rate signals to decide what to buy, and instead follow what central banks do.

In the 1990s, the market began to follow the Fed’s rate announcements, with investors expecting interest rate cuts to stop the market wobbling. More signalling than serious action, hints of rate cuts were enough to steady nerves. But when medicine is overused, ever-larger doses are needed and have less effect, until everything goes downhill.

In the 2008 global financial crisis, the Fed and European Central Bank borrowed the idea of quantitative easing from the Bank of Japan, the first to bring interest rates to near zero and use its balance sheet to create easy money conditions to help Japan recover from deflation.

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