What Options Are Left for Central Banks? (October 15, 2014)
Central banks have reached a fork in the road.
Never before have quasi-omnipotent financial gods had so few powers. A lot is being written about central bank policies now as the Federal Reserve ends its primary quantitative easing (QE) program and the limitations of central bank easing become increasingly apparent in Europe and Japan.
Let’s start by listing the tools central banks have on hand. Strip away the fancy footwork and econospeak mumbo-jumbo, and what’s left is:
1. Offer cheap credit to the banking sector, the idea being that the banks will use the free money to make loans to households and businesses. These new loans would inject the central banks’ new money into the real economy.
2. Buy bonds to push interest rates down and buy mortgages to support the housing market.
3. Provide unlimited liquidity so banks and key financial institutions facing a liquidity crunch have a lender of last resort.
The basic idea here is that central banks provide a buffer against financial crises. When short-term loans come due and the borrower has run out of cash, rather than slip into insolvency they can borrow short-term money from the central bank.
The ability to push down interest rates is helpful as a buffer when credit-tightening and fear of defaults push interest rates up enough to choke off normal lending.
What happened over the past six years is that central banks have moved from providing short-term buffers to being the saviors of the government, economy and asset markets. This is an extraordinary transformation, and it’s the core reason why central bank policies are now failing to move the needle: they were designed to serve as short-term buffers during crisis and the resulting recession, not permanent props under government borrowing, the financial sector and the stock, bond and real estate markets.
