A central bank credibility test looms over potential bond losses

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This year’s bond bear market around the world raises a pressing question regarding central banks’ balance sheets. These are greatly expanded as a result of asset purchases, or quantitative easing, in response to the financial crisis and pandemic.

However, the US Federal Reserve and other central banks in developed countries are terribly undercapitalized compared to private sector banks. So they are extraordinarily vulnerable to losses in their bond portfolios. They also face unprecedented credit risk on illiquid and elusive assets acquired through their operations as lenders and market makers of last resort. Should the markets worry?

The traditional central bank response is: not to worry. The job of central banks is to pursue lofty goals such as price stability, not profit maximization. As Willem Pewter, a former member of the Bank of England’s Monetary Policy Committee, has long argued, its balance sheet is anyway a misleading guide to financial strength in that it does not include their most valuable asset: property, or money-making profit.

Any view of central banks’ solvency must reflect the fact that they can save themselves simply by issuing core money – commercial bank money and deposits held at the central bank. So even if a traditional balance sheet is technically insolvent, they will have no trouble meeting their obligations when they fall due.

The presumed argument for indifference is that many central banks, including Chile, the Czech Republic, Israel and Mexico, have operated without difficulty despite having negative equity on their balance sheets for extended periods. They did this because of their credibility over the monetary and financial stability of the time.

Whether the same can be said of the major central banks after a prolonged episode of ultra-low interest rates is a matter of debate. This morally hazardous policy contributed to unprecedented levels of debt in peacetime. Since the financial crisis, central banks have dramatically increased their exposure to the market, interest rates, and credit risk. And with regard to their central mandate of price stability, they have failed miserably to anticipate accelerating inflation. As the Bank of England’s recent firefight to tackle stock market volatility caused by unbundling pension fund investment strategies has shown, some have also been slow to pinpoint where excessive leverage is located in the non-bank financial sector.

The perverse enthusiasm of retail investors for volatile crypto-assets is also an unfortunate judgment of independent monetary policy-making because it is largely driven by a lack of confidence in central banks’ management of fiat currencies.

The inescapable fact is that central banks cannot recapitalize themselves in bankruptcy through liquidity without generating unacceptably high inflation. The opinion that they can always print their way out of trouble is delusional. In any case, central bankers worry about their balance sheets as they worry about market perceptions and politicians’ reactions.

In some cases this concern is formalized. For example, the European Central Bank requires national central banks in the monetary union to avoid prolonged negative or negative stocks.

It follows from all this that it is not enough for politicians to hold central banks accountable for policy only. In a recent paper, Paul Wessels of De Nederlandsche Bank and Dirk Broeders of Maastricht University argue that sufficient capital is necessary to maintain confidence that a central bank is effective in implementing monetary policy and is able to absorb financial risk independently of the government.

It would be impossible to create a single capital adequacy system for central banks. With quasi-fiscal measures such as quantitative easing, where the taxpayer is exposed, risk ownership is shared differently between governments and central banks from country to country.

When compared to the private sector, capital adequacy will also be an imprecise system because the incidence and magnitude of financial liabilities arising from lending of last resort and market making are inherently unknown.

For the Fed, capital adequacy is not an issue for other central banks. It remains the custodian of the world’s pre-eminent reserve currency, and markets seem reassured by the Fed’s policy tightening this year. Unfortunately, the extreme weakness in central bank balance sheets is a symptom of how advanced economies have come to operate with lower margins of safety.

john.plender@ft.com

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