Central banks: on-side or outside?

17 April 2020

How much “support” should central banks give their Covid-19 stricken economies and how? While all eyes have been on the fiscal responses, what tools remain in the monetary policy armoury? flow´s Clarissa Dann looks at Deutsche Bank Research and central bank insights on short and long-term economic rescue remedies

Some 10 years before the Global Financial Crisis, Long-term Capital Management (LTCM) – a large hedge fund with US$126bn in assets, hit the wall. Its founders were experts in investing in derivatives to outperform the market.

In the summer of 1998, the markets went sour in response to financial turbulence in Asia and then Russia. As the New York Times1 put it, “with terrifying suddenness bond markets turned skittish and all the fund’s gambits ran into trouble”. By September, LTCM was close to bankruptcy, at which point a group of 14 banks and brokerage firms invested US$3.6bn to prevent the hedge fund’s imminent collapse. The arrangement was facilitated by the Federal Reserve, though the Fed did not lend any of its own funds.1 This intervention, which some observers deemed to be unnecessary in the first place, continues to raise questions to this day about central bank protection of private financial institutions.

After years of very low or negative interest rates, and huge quantitative easing programmes to stimulate demand, what roles do central banks and monetary policy intervention have in getting economies past the pandemic crisis without mortgaging the future up to the hilt?

Pandemics are different

In a Financial Times essay (18 March) Former Federal Reserve Chairs Ben Bernanke and Janet Yellen make the point that central banks’ response to the coronavirus disruption is very different from the 2008 Global Financial Crisis when “the near-term collapse of the financial system froze credit and spending; the goal of monetary policy was to restart both”. They explain, “Now, the problem is not originating from financial markets: they are only reflecting underlying concerns about the potential damage caused by the coronavirus pandemic, which of course monetary policy cannot influence.”3

European Central Bank President Christine Lagarde calls for a collective approach, “Health and fiscal policies must be front and centre in this response. Monetary policy has a vital role to play in tandem,” she said on 19 March4” Monetary policy has to keep the financial sector liquid and ensure supportive financing conditions for all sectors in the economy. This applies equally to individuals, families, firms, banks and governments.”

According to Lagarde, any tightening in financing conditions would “amplify the harm of the coronavirus shock at a time when the economy needs more support”.

Bernanke and Yellen believe policymakers have a responsibility to “ensure that the economic damage from the pandemic is not long-lasting. Ideally, when the effects of the virus pass, people will go back to work, to school, to the shops, and the economy will return to normal”. The question for many economic observers is what “normal” will look like given the existing levels of debt – something Deutsche Bank Research analysts pointed out in their paper Impact of Covid-19 in the global economy: Beyond the abyss (30 March 2020).5

Central bank independence from politics is relatively new, notes the International Monetary Fund (IMF) in Central Bank Accountability, Independence, and Transparency (November 2019)6 and has proved “a valuable, stabilising force for countries seeking politics-free monetary policy decisions” (see Figure 1). The IMF continues, “But a decade after central bankers became pivotal actors in the Global Financial Crisis, central banks around the world are striving to fulfil their mandates under difficult circumstances.”

Figure 1: IMF perspective on central bank independence

State-sponsored capitalism?

The sheer scale of current Covid-19 policy responses has its roots in bail-out habits built up over the past 25 years, notes Deutsche Bank Research Analyst Jim Reid.

“Ever since the Fed of the late 1990s decided to bail out the financial system post the LTCM collapse, we’ve had rolling state sponsored capitalism and large moral hazard,” he said in his daily bulletin Early Morning Reid: Macro Strategy on 14 April 2020. He continued, “ This has meant that each subsequent default cycle (or mini market cycle) has been less severe than the free market parallel universe version would have been and has left increasingly more debt in the system as a result and meant that the intervention necessary to protect the system has got greater and greater. In my opinion, it also helps lock in lower productivity as you keep more low/no growth entities alive.”

While Reid stresses that in the face of a global pandemic, “there has to be some sympathies with these policies”, he concludes, “had markets not been repeatedly bailed out over the last 20−25 years the authorities wouldn’t have needed to be as aggressive”.

Impact on currencies

George_Saravelos“There is no such thing as a free market anymore. All developed central banks have cut rates to zero and are buying trillions of assets. Inflation is very low,” declares George Saravelos, Head of FX Research at Deutsche Bank (pictured) in the first of a series of FX Special Reports, The end of the free market: impact on currencies and beyond (9 April 2020).

In an environment where “a global liquidity trap may be in the making” and in a world of “international yield curve control and administered asset prices” he asks what this all means for FX. Low volatility rates should mean low volatility in FX, according to classical economic theory, he notes. But if central banks cannot change yields or inflation, “nothing changes in exchange rates either”, explains Saravelos, the result being that central bank interest rate announcements lose their relevance for FX, “just like the Bank of Japan has lost relevance for the yen in Japan”.

A helpful illustration of this principle can be found in the Monetary and Economic Department at the Bank of International Settlements’ collection of BIS papers No 737, which reports on a discussion of papers presented at the meeting of Deputy Governors of major emerging market economies (EMEs) in Basel on 21–22 February 2013.

The participants agreed that “a flexible exchange rate plays a crucial role in smoothing output volatility in EMEs” but “a highly volatile exchange rate can increase output volatility and itself become a source of vulnerability”.

In addition, they add, “Most official forex interventions in EMEs were intended to stem volatility rather than to achieve a particular exchange rate” and “exchange rate intervention needs to be consistent with the monetary policy stance and persistent, one-sided intervention, associated with sharp expansion of central bank balance sheets, creates risks for the economy”. 

Returning to the issue of policymaker control and their position, which Saravelos sees as a “backstop for private-sector credit markets”, there is a concern, he explains that “at the extreme, central banks could become permanent command economy agents administering equity and credit prices, aggressively subduing financial shocks”.

If this happens, he reflects, we are staring at “a bi-polar world of financial repression with high real income volatility, but very low financial volatility” – in others words, “a zombie market”. The impact on FX volatility of this scenario is far more ambivalent and could well be negative, says Saravelos.

He reminds us that “an emerging global liquidity trap also means that the exchange rate becomes an increasingly important instrument for central banks. Policymakers can always impact FX via selling infinite amounts of their own currencies. If the central bank focus returns to FX this could be a new source of volatility.”

On 16 March Reuters reported that the Swiss National Bank (SNB) lifted its currency market interventions to their highest level in more than three years8, as it battles against the rising value of the safe-haven Swiss franc. That day, said the news agency, sight deposits (money that commercial banks park with the SNB overnight) “increased to CHF602.992bn (U$640.05bn) from CHF598.548bn in the previous week”.

Adjustments should not undermine the long-run credibility of financial policies. Credibility is hard to gain and easy to lose
Bank of International Settlements

Back to the long-term

Developing Reid’s point about past crisis responses, the lesson is that temporary measures to tackle an economic emergency need to stay temporary and not become compounded into some sort of habit or “new normal”. This is also the message spelt out by BIS in Reflections on regulatory responses to the Covid-19 pandemic9 (April 2020). “Adjustments should not undermine the long-run credibility of financial policies. Credibility is hard to gain and easy to lose. Compromising the policies excessively in the short run can create serious long-term damage. From this perspective, adjustments should be, and seen to be, temporary. Transparency is key in meeting this principle.”

Summary of Deutsche Bank Research reports referenced

  • Impact of Covid-19 on the global economy: Beyond the abyss (30 March 2020) by David Folkerts-Landau, Peter Hooper, Mark Wall, Matthew Luzzetti, Michael Spencer, Stefan Schneider, Yi Xiong, Kentaro Koyama, Torsten Sløk, Juliana Lee, Binky Chadha, Jim Reid, Francis Yared, George Saravelos, Justin Weidner, Surav Dasgupta, and Kuhumita Bhattacharya
  • Early Morning Reid: Macro Strategy on 14 April 2020 by Jim Reid
  • FX Special Reports, The end of the free market: impact on currencies and beyond (9 April 2020) by George Saravelos

Deutsche Bank clients can access the full research reports here
If you would like access do contact a Deutsche Bank sales representative



1 See https://nyti.ms/2RJ2SD2 at nytimes.com
2 See Federal Reserve History here
3 See https://on.ft.com/2LA5Bir at ft.com
4 See https://bit.ly/2VbpxKp at ecb.europa.eu
For more on the cost of fiscal responses see flow’s “Towards a silver lining” (3 April 2020)
6 See https://bit.ly/3bcTL5u at imf.org
7 See https://bit.ly/2wJagai at bis.org
8 See https://reut.rs/35EPoPP at reuters.com
9 See https://bit.ly/3aiz5HH at bis.org

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