Sometimes the best analysis of current conditions can be found in research written at a time when such conditions seemed only theoretical. This is because people writing about them have no hidden agenda and usually do it out of sheer intellectual curiosity. I have recently come across one such example when I was trying to figure out what the nature of the Fed/BoE/BoJ/ECB exit strategy will be. Whenever it may come, that is.
Here’s the link to the research entitled “The role of central bank capital revisited” published in September 2004 by the ECB. Interestingly, the paper was written by gentlemen with very German-sounding names (Ulrich Bindseil, Andres Manzanares and Benedict Weller). It reminds me of another ECB paper which in 2009 discussed “Withdrawal and expulsion from the EU and EMU” written by a Greek (Phoebus Athanassiou), but I digress.
I encourage you to take a minute and read at least the non-technical summary of this paper. Below are a few interesting quotes:
- It is shown that a temporary shock creating negative capital and a loss-making situation is always reversed in the long run with the central bank returning to profitability and a positive level of capital.
- However, a central bank with a loss-making balance sheet structure would in this context still able to conduct its monetary policy in a responsible way, even with a negative long-term profitability outlook.
- Positive capital seems to remain a key tool to ensure that independent central bankers always concentrate on price stability in their monetary policy decisions.
The last one is a widely accepted notion but the former two can make you go “hmmmm”. Additionally, further in the paper the authors mention a key feature: “If there were no separation between the central bank and the government, the capital of the central bank is obviously irrelevant since one then has to consider only the aggregate capital of the State (including the central bank and the government).“
The authors also mention that if a central bank has a negative capital then “The markets will have reasons to anticipate less stability-oriented behaviour of the central bank, which drives up inflationary expectations.” This catapults us straight to the current situation.
It would be remarkably difficult to argue that the BoE, BoJ or even the Fed are fully independent. Sure, they are not parts of their respective governments nor do they report to politicians (directly) but independence is illusion. This is particularly the case considering that they own the lion’s share of their local government bond markets, which many commentators perceive as a situation without an obvious exit. But let’s try and assume the unthinkable…
Imagine that efforts of the Federal Reserve eventually lead to some sort of stabilisation of growth, albeit at a low level. Assuming a fast growth rate is a bit too audacious even for me… Now surely this will raise the question of the Fed’s exit strategy. We can reasonably assume that the minute the market gets a sniff of selling of the Fed’s UST portfolio, things can get nasty. Granted, the Fed is wary of those risks and will try to minimise the impact but at the end of the day it will be a classical “more sellers than buyers” situation. As a side comment, it is entirely possible that the Fed starts with what one of my friends called Operation Untwist, i.e. selling the back end to buy short-maturity papers. This is bound to hit the central bank’s profitability. And so what?
Let’s say that the Fed adheres to the mark-to-market principles. Every bond that it sells makes the unsold portfolio look more and more under-water (all other things equal). Depending on how big the move in yields is, we can assume that the capital would be wiped out relatively quickly. The authors of the aforementioned article indicate that such a situation would “drive up inflationary expectations”. Now, hang on a minute – isn’t it what many central bankers are dreaming about? Wouldn’t that in the end increase velocity of money giving an additional boost to the economy?
The IMF analysed central banks’ losses too and concluded that if the central bank “goes bankrupt”, the risk of dollarisation of the economy increases sharply. I would agree with that when we talk about countries like Nicaragua or Egypt. But surely not in the US. It is remarkably difficult to imagine why would the Americans start preferring any other currency than the USD just because the Fed made some losses on its UST portfolio (and please don’t say “gold”). I admit that this is a slippery slope but a very important consideration at the moment is the liquidity trap and there are no easy ways out of it as many countries have painfully discovered lately (see my previous post “Has Britain finally cornered itself?“).
One of the models that the ECB study introduces spews out a nice chart:
This shows that a central bank’s capital does not have to turn negative to drive inflation a bit higher. Perhaps then we should not be too worried about what happens to the Fed when yields finally rise? Let me make an analogy to the momentum principle and space travels. When a rocket reaches outer space, a good way to boost velocity is to detach a part of the rocket which will essentially push the main chamber further and faster into space. This is pretty well explained here and can be summarised in the following diagram I have nicked:
Sometimes it is good to take a step back to achieve the required effect. Perhaps a central bank incurring some losses while selling its government bond portfolios is a way to go after all…