The changing world of central banking

In late 2010, with the financial crisis already two years old and equity markets well into the early stages of their recovery, I was discussing the outlook for central banking and monetary policy with a former colleague at the Bank of England. “How long”, I asked him, “do you think it will be before we are back to normality?  How much longer do you think we will have these very low interest rates?”

He looked at me and after some thought said “We don’t admit this publicly too often, but this is a much deeper and more serious crisis than most people realise. I suspect we are only half way through it”.

I met him again some three years later and reminded him that in 2010 he had offered the thought that we were “half way through the crisis”. Yet here we were in 2013, and interest rates were not only still rock bottom, but central banks had started QE.  What had changed to make his earlier prediction wrong?

He replied “There was nothing wrong with my prediction and I hold exactly the same view today. We are still only half way through the crisis”.

Three years on again, and interest rates are even lower – indeed in several countries official rates are negative – and central bank balance sheets larger and their market activity yet more dominant in markets. Indeed, there is a significant risk that central banking is following “the route of the three Ds” – first they tried through their forward guidance to Direct markets, then through their QE and other market interventions they aimed to Distort markets, and now many fear that through their dominant position in many asset classes there is a growing danger that they may Destroy markets.

Only last week the Bank of Japan unveiled their latest strategy to bend markets to their will, with a policy designed to keep Japanese government bond yields for all bonds up to 10 years in maturity below zero. Not content with directing short term rates, therefore, the BoJ is now nakedly manipulating the bulk of the JGB yield curve.  But the more that central bank activity dominates markets, the less those markets can provide any form of independent opinion or signal back to the central banks (as someone at the ECB lamented to me, “when all you hear is an echo of your own acts there is no information”).  And when the markets no longer consist of a willing buyer and a willing seller, then there is no guarantee that the market price is a fair price and no concept of fair value for investors to steer their portfolios by.

To be fair to central bankers, they are well aware of these dangers, and they have been as keen as anyone to return to the world before the crisis of more orthodox levels of interest rates, smaller central bank balance sheets and less direct involvement in markets.  And underlying this is an enduring belief, shared by central bankers and the market alike and half way between an article of faith and a fervent hope, that although crises come and crises go, the essence of central banking is constant or at best very slow to change.  There is a real sense in central banking circles that even quite substantial policy regime shifts are merely deviations from some pre‑ordained norm, and that in due course central banking will “return to normal”.

Markets, and investors, like this.  There is comfort in the belief that however difficult markets are right now, they will in due course return to more orthodox and understandable patterns.  But at some point, the reality sinks in:  the world really has changed, there will be no return to the status quo ante, and where we are now is indeed the new orthodoxy.  In short, central banking has moved to a New Normal.  And then everyone – markets, investors, central bankers themselves – have to accept the new normal and work out what it means.

We appear to be approaching this point, and it is probably time to accept that central banking really is in a new paradigm, and that the ultra-low interest rates we have experienced for the last seven or more years are no longer an aberration which will be rectified in due course but the shape of things to come for the foreseeable future.

Certainly central bankers themselves seem to be finally coming to this conclusion.  At two major central banking conferences this summer – the ECB meeting at Sintra in June and the meeting of the US Federal Reserve at Jackson Hole, Wyoming in August – there was much discussion about the changing role of central banks and how permanent the “crisis response” to the Great Recession of 2007-09 would be.  This is not the first time central bankers have debated the point of course, far from it, but for the first time the general consensus appears to have been that where we are now is indeed likely to be the pattern for many years yet.

What does this mean?  For investors, it means that the current era of very low interest rates and market-active central banks will continue, probably for a number of years.  Of all the world’s major central banks, only the US Federal Reserve is considering raising interest rates – and even they are being extremely cautious and deliberate about actually doing so. Having said when they started raising rates in December 2015 that they anticipated “3 or 4” further rises in 2016, we are still waiting for the first of them and at the most recent FOMC meeting earlier this month, the decision was again deferred.

For central bankers themselves, it is likely to postpone even further into the future their return to relative anonymity.  Gone are the days when the actions of the central bank were reported briefly on the business pages and followed only by a small band of specialists.  The modern central bank governor is a prominent figure, and their actions are as much political as financial.

In part this is inevitable, given that their decisions on interest rates and markets affect so many people – redistributing wealth from savers to borrowers, from pensioners and those living off interest income to investors and those owning financial assets.  But it also reflects two other factors:  firstly, there is no obvious exit strategy for central banks, as the discussions last summer at Sintra and Jackson Hole seem to have concluded.  And secondly, even if there was, it suits their political masters very nicely to have central bankers so active.  Finance ministers with limited room (or desire) to use fiscal policy are more than content to let their central banks undertake most of the heavy lifting to keep economies alive.

And at least one central bank governor seems both to have realised this and even welcomed it.  Mark Carney, the Governor of the Bank of England, has always been a political governor – for him, the post at the Bank was clearly designed as a stepping stone in a career that will no doubt at some stage return to Canadian politics.  And initially he asked for, and was granted, a let-out from his 8 year contract which would enable him to step down after 5 years.  Now, he seems to be enjoying the limelight of Threadneedle Street (and even the cut-and-thrust of political exchanges over his role in the summer’s referendum) so much that he is talking openly of serving all 8 years.  (Though the sceptics might also observe that Carney’s keenness to stay in the UK is perhaps also because the position of “good looking debonair young man” in Canadian politics is no longer quite so vacant with the rise of prime minister Justin Trudeau).

Investors have fair warning.  The era of active central banks, ultra-low interest rates and prominent and political central bankers is likely to be with us for some time yet.  And in the UK, for a few years more at least, the Bank will probably continue to speak with a Canadian accent.