Global Central Banks starting to bend their heads to interest rates gamble of money market dealers? Another Global Economic Shock worse than the Pandemic Shock is Ahead….
Rising Inflationary Pressures across the Globe
During last few months, inflation as measured by the increase in consumer price index (CPI) has started rising rapidly over the inflation targets adopted in many countries. The increase in inflationary pressures is seen especially significant in developed countries operating with largely free market forces. At the beginning, central banks considered such inflationary pressures as transitory.
Their reasoning has been that inflationary pressures were a result of global supply side bottlenecks and energy price hikes caused by the reopening of economies after getting the Corona pandemic under the control and, therefore, such inflationary pressures would fade away once supply chains are restored gradually.
However, many central banks now tend to believe that present inflationary pressures are at elevated levels persistent longer than initially expected and likely to continue in 2022 before they tend to converge around the target inflation levels over the medium-term.
Rising Trend of Market Interest Rates
Central banks mainly intervene in overnight interest rates in the inter-bank market through policy rates and open market operations. However, other short-term and long-term interest rates are determined by market forces where money market dealers play a major role primarily through trade in government securities and the yield curve as the basis for determining the risk premium and interest rates for private debt securities in general.
In addition to credit risk premium, the premium charged for expected inflation frequently drives the money market interest rates because investors always attempt to protect the real interest rate or real returns. Accordingly, market interest rates are moved by changes in inflation expectations over the investment horizon. This is the standard practice of investors and money dealers.
Accordingly, market interest rates globally have been in a rising trend in response to rising inflationary pressures in the past few months although central bank policy interest rates have been kept unchanged. Money dealers are aware that central banks also would adjust their policy interest rates sooner or later to prevent policy interest rates becoming outliers in the present market-based monetary policy models.
Further, as central banks primarily target the price stability or control of inflation in their monetary policies, they naturally tend to tighten the monetary policy over a gradual phase to anchor inflation expectations of the general public. In this background, money dealers readjust their lending/investment portfolios for profit by speculating on monetary policy adjustments in that line.
Immediate Monetary Policy Response from Leading Central Banks
Accordingly, several central banks including the US Federal Reserve (Fed), Bank of England (BoE) and European Central Bank (ECB) have embarked on a tightening phase of monetary policies that have been kept at historically relaxed levels during the past 22 months to help economies recover from the global Corona pandemic.
In the review of monetary policy decisions taken in this month, it is now clear that these central banks have firmly commenced a tightening phase in line with market expectations and recommendations to fight the rising inflationary pressures by resorting to conventional monetarist hypothesis. However, their policy messaging is quite confused.
They all state that the economies have strongly rebounded from the Corona pandemic with a strong labor market with unemployment falling to 4% although inflation has risen significantly consequent to supply side bottlenecks and global energy price hikes with continued uncertainties, especially from the new Omicron variant. The increase in inflation from September to November 2021 is reported as from 5.4% to 6.8% in the US, 3.1% to 5.1% in the UK and 3.4% to 4.9% in the EU as compared to the monetary policy longer term inflation target of 2%.
Further, they expect inflation levels to fall towards the target 2% over the medium-term as no signs of second round effects through wage increases are discernible and acknowledge the possibility of adverse impact of policy tightening on the supply side and employment, in which case, they are prepared to recalibrate policy instruments to deal with any downside macroeconomic risks. Therefore, the economic rationale for the commencement of the policy tightening so soon seems to be quite questionable, given the significant pandemic-related uncertainties and supply chain bottlenecks still prevailing across the globe at elevated levels caused by the Omicron variant. Therefore, some analysts comment that central banks have become panic in place of the required patience.
The latest monetary policy decisions of the Fed, BoE and ECB are highlighted below.
- Federal Reserve (Fed) – 15 December 2021
Beginning in mid-January, the monthly pace of our net asset purchases is to be reduced by $20 billion for Treasury securities and $10 billion for agency mortgage-backed securities. Accordingly, the increase in securities holding of the Fed through net asset purchases would cease by mid-March 2022.
The Fed has been purchasing securities at a monthly phase of $80 bn of Treasury securities and $40 billion of agency mortgaged-backed securities to inject new liquidity under the Quantitative Easing (QE) policy implemented to deal with the Corona pandemic risks. However, at the previous policy meeting held on 3 November 2021, the Fed commenced slowing the phase of this purchase by $10 billion for Treasury securities and $5 billion for agency mortgage-backed securities in November and December consecutively. Therefore, with the present decision, the purchase will further decline by $20 billion and $10 billion monthly, respectively, so that the purchase will cease in March 2022.
This shows the curtailment of the growth of the Fed balance sheet and new money printing. However, new money printing is not expected to cease as the Fed will rollover/reinvest all maturity proceeds of these securities existing in the Fed balance sheet. Therefore, the Fed has not considered yet any time targets for reduction/tapering in the Fed balance sheet and the policy rate hike from the present levels.
The present Fed balance sheet is around $ 8,756.7 billion as of 15 December 2021 reflecting an increase by 109% from its level as of the end of 2019 and the policy interest rate corridor (federal funds rate target range) is 0-0.25%. The interest paid on bank excess reserves also remains at 0.15%.
- Bank of England (BoE) – 16 December 2021
The Bank Rate was raised from 0.10% to 0.25% as most market participants predicted. In fact, heavy market pressures were exerted on the BoE to raise the Bank Rate to 0.25% at the previous policy meeting too held on 2 November 2021. Therefore, the BoE was heavily criticized for keeping the Bank Rate unchanged despite the rising inflationary pressure.
However, the BoE has decided to continue with the net asset purchase programme or the QE introduced under Corona pandemic-based monetary policy. Accordingly, the stock of sterling non-financial investment-grade corporate bond purchases up to £20 billion and government bond purchases up to £875 billion (total £895 billion) will be maintained.
Therefore, the BoE has chosen the policy rate hike path of the policy tightening in contrast to that of the Fed.
- European Central Bank – 16 December 2021
The ECB has maintained a monthly net asset purchase pace of €40 billion in the second quarter 2021 and €30 billion in the third quarter under the normal Asset Purchase Programme (APP). As decided at the previous policy meeting held on 28 October 2021, the ECB decided to continue it at a monthly pace of €20 billion from October onwards for as long as necessary to reinforce the accommodative impact of its policy rates. The ECB expects net purchases to end shortly before it starts raising the key ECB interest rates.
Further, reinvestment, in full, the principal payments from maturing securities purchased under the APP will continue for an extended period of time even after the ECB starts raising the key policy interest rates.
In addition, net asset purchase under the ECB’s Pandemic Emergency Purchase Programme (PEPP) will continue at a lower pace than in the previous quarter up to the total stock of €1,850 billion until it will be discontinued at the end of March 2022. Further, the reinvestment of the principal payments from maturing securities under the PEPP will continue until at least the end of 2024. However, the net purchases under the PEPP will be resumed, if necessary, to counter any negative shocks related to the pandemic.
Further, ECB’s key policy interest rates, i.e., main refinancing operations rate, marginal lending facility rate and deposit facility rate at 0.00%, 0.25% and -0.50%, respectively, and long-term refinancing operations will remain unchanged.
Accordingly, the ECB has chosen the tightening path for new money printing similar to that of the Fed.
Possible Consequences of Monetary Tightening to Developing Countries
In view of the past experience, the policy phase followed by the US Federal Reserve, Bank of England and European Central Bank would cause a corresponding policy wave across the globe as the currencies issued and regulated by those three central banks are the most popular reserve currencies in the developing world. Therefore, whole world is looking at what those three central banks would do in their monetary policies. The transmission route of their policy changes is the flow of financial market investments between those countries and developing countries.
In the case of policy tightening cycle, investments would flow back to developed countries seeking safer returns, given the risks in developing countries despite higher interest rates maintained in those countries. This was well evidenced when the Fed tightened the monetary policy by raising interest rates faster during 2017-2018 as it caused a near currency crisis in many developing countries due to outflow of foreign investments, despite competitive rates hikes implemented in those countries to discourage the outflow.
At present, many developing countries already confront an acute shortage of foreign currencies, despite the abundance of reserve currencies in the global financial markets attributable to the historically relaxed monetary policies of developing countries in response to the Corona pandemic. However, disruptions in global supply chains including investments due to the pandemic-related uncertainties have caused significant erosion of foreign currency flows available to developing countries. As a result, some countries that are dependent on imports and foreign debt are confronting acute macroeconomic problems including erosion of living standards.
Therefore, if the developed countries continue to tighten the monetary policies in the event their inflationary pressures are not subdued in the near future, macroeconomic risks to developing countries will be further aggravated by both monetary tightening wave followed in these countries and further erosion of foreign currency flows. Few developing countries have already commenced the tightening of monetary policy by raising interest rates and confront rising risks to the growth and inflation.
For example, the Central Bank of Sri Lanka commenced policy tightening on 18th August 2021 even before developed country central banks by raising concerns over possible future inflationary pressures, regardless of the poor performance of the economy on all fronts. Accordingly, the policy interest rates were raised by 0.50% (to 5.00% and 6.00%) with the increase in statutory reserve ratio by 2% to 4%. In addition, daily monetary operations have been carried out aggressively through repo auctions (mainly overnight and 7-days) and outright sale of Treasury bills in the secondary market to mop up the inter-bank liquidity in order to raise money market interest rates.
As a result, Central Bank’s overnight repo rates was raised closer to 6.00% (i.e., by one to two basis points below 6.00%, the upper bound of policy rates corridor). Therefore, the Central Bank has incurred in an additional interest cost in the conduct of overnight repo auctions by paying 98-99 basis points higher than the Central bank overnight deposit facility rate 5.00%.
Further, the aggressive mop up of the liquidity from the banking system for the purpose elevating the overnight inter-bank rate closer to 6.00% has led the banking system to become the overnight net borrower from the Central Bank as against the overnight net depositor at the Central Bank prior to 18th August 2021. For example, the average net overnight deposits amounted to Rs. 37.9 bn for the week prior to 18th August 2021 whereas it became a net overnight borrowing of nearly Rs. 345 bn for the current week ending 17th December 2021. As a result, the overnight inter-bank interest rate has increased by 0.83% to 5.92% during this period.
However, the corresponding increase in short-term interest rates during this period has been excessive. The average of Treasury bill yield rates at weekly primary auctions rose by nearly 2.45% from 18th August to 15th December as compared to the decline of nearly by 2.64% from 11th March 2020 to 18th August 2021 in response to the reduction in policy rates by 2% and SRR cut by 3% together with historic increase in Treasury bill holding of the Central Bank by Rs. 1,096.2 bn. Therefore, the government’s fiscal funding cost required for keeping the pandemic-hit economy running at current phase has considerably increased due to this bank liquidity crunch artificially created by the monetary policy. As such, this money market liquidity crunch is not second to usual shortages artificially created by administrative price controls in commodity markets.
As a result, the government could raise only 79% of the total funding requirement of Rs. 1,025.2 bn announced for weekly auctions, mainly 91-day bills (84.2% of funds raised), due to speculative interest rates consequent to monetary tightening wave where the Central Bank had to directly subscribe nearly Rs. 198.3 bn to weekly Treasury bill issuances through money printing for the purpose of control of auction yield rates, which would cause further monetary expansion in contrast to the new monetary policy stance. Therefore, the increase in debt rollover cost to the government is considered significant. Further, the additional interest cost to the corporate sector is reflected by the increase in the prime lending rate by 2.45% to 8.16%.
Therefore, the control of primary auction Treasury bill yield rates can be considered de facto short-end yield curve control-based monetary policy without announced targets. As such, the present sort of hasty monetary tightening followed by the Central Bank/Monetary Board does not seems to have any macroeconomic rationale in the current context of the pandemic-hit economy and disrupted living standards, other than the compliance with the routine job descriptions prescribed by the Monetary Board for respective Central Bank officials.
The IMF also has warned of the adverse impact of the impending monetary tightening on the global economy in view of the present stock of debt significantly risen ($ 226 trillion at the end of 2020 being the largest one-year debt surge since the World War II due to the fight with the Corona pandemic) on rising interest cost and constraints on fiscal accommodation still in need in the event global interest rates rise faster than expected while growth weakens. Further, global monetary policy tightening, if continues as envisaged, would cause even financial crises in developing countries due to liquidity crunch and acute shortages of foreign currency, in view of the systemic risks arising from the monetary front.
As such, the recovery of living standards from the pandemic in the developing world will drag for decades due to the monetary tightening cycle if continued by the developed countries. Therefore, incumbent governments and policymaking authorities in many developing countries will confront enormous public unrest if they fail to stabilize the economies and living standards back at pre-pandemic levels without further delay before the envisaged monetary policy tightening takes off. This requires the adoption of a new macroeconomic governance system in place of the present uncoordinated/segmented macroeconomic/market management systems.
(Several articles of this author on the present monetary policy stance are available in the blog “Economy Discovery” linked to this blog which is newly launched to share author’s views and research in English version.)
P Samarasiri
Former Deputy Governor, Central Bank of Sri Lanka
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