Central banks showed they had learned a thing or two from the 2008-09 financial crisis as they successfully navigated an unprecedented pandemic and lockdowns this year. They reacted forcefully to keep markets from freezing up, creating money to stabilize markets and indirectly finance massive deficit spending.
But it came at a cost. Central banks have come perilously close to playing a political role. In particular, the US Federal Reserve crossed a line when it set up emergency lending facilities backed by government funds.
How Compromised Have Central Banks Become?
The last-minute hurdle in congressional negotiations over the weekend to provide much-needed relief in the final stages of the pandemic demonstrated the point. Republican senators blocked the aid, including checks to individuals, to keep the Fed from reviving the facilities Treasury Secretary Steven Mnuchin had shut down. They wanted to avoid an end-run around aid approved or not approved by Congress, and particularly the Municipal Liquidity Facility for loans to local and state governments.
An eleventh-hour compromise limited the ban to duplication of the facilities shut down, not to Treasury backstopping of Fed lending in general. The vote on the relief package as well as a catch-all spending bill is expected Monday.
What is the Fed doing in the middle of a political battle? Good question, and hopefully Fed chairman Jerome Powell and other policymakers will agonize over the answer in the coming months.
The Fed is not alone, however, in getting caught up in politics. The European Central Bank increased the amount of its Pandemic Emergency Purchase Program by €500 billion in December, so that with a total €1.85 trillion in its war chest the ECB can meet much of government finance needs.
The fact that the purchases are made in the secondary market instead of directly from governments is the barest fig leaf that hardly hides the fact this is the very central bank finance of government debt prohibited by European Union treaties.
A central bank’s gotta do what a central bank’s gotta do, and nobody wanted to quibble when facing economic collapse. But once vaccinations are rolled out and economies come roaring back, it will take some sorting out to figure out not whether central banks have been compromised but to what extent this has occurred.
The pandemic demonstrated the institutional resilience of the financial system. Not only did central banks react vigorously, banks withstood the stress after being forced to build up capital. A ban on dividends and share buybacks was a necessary safeguard, much as banks chafed under this temporary measure. Last week, the central banks largely lifted the bans under certain restrictions.
But the institutional backbone could not disguise the weakness at the top of the most important central banks. Neither Fed chairman Powell nor ECB president Christine Lagarde have the requisite qualifications to manage a crisis.
Both are lawyers who made the marks in other spheres. Powell at least had on-the-job training before he took over the top post and made his rookie mistakes before the crisis hit. He has learned to stick to the script written for him by people who understand what’s going on.
Lagarde had no central banking experience and it showed as she time and again displayed a lack of sensitivity to how markets would react to her remarks. ECB chief economist Philip Lane, former governor of the Central Bank of Ireland, had to step in and start phoning up big investors to “clarify” Lagarde’s miscues. It’s too bad someone like Lane, or like Lagarde’s predecessor, Mario Draghi, does not occupy the position that requires a person who can speak with authority.
Even Andrew Bailey, the governor of the Bank of England, found his authority weakened as scandals piled up from the period when he headed the UK’s Financial Conduct Authority. At least he had a long career at the central bank before his ill-advised appointment to the regulatory agency.
Central banks ended the year with a whimper instead of a bang as they waited on tenterhooks to see how quickly economies can recover once vaccinations become widely available.
After telegraphing its intentions for weeks, the ECB low-balled its added bond purchases, meeting just the minimum of what investors had come to expect, which disappointed many. Some policymakers said they would probably not even use all of funds available, but in that case, why not err on the side of too much? Investors are nervous creatures and perception counts for a lot.
The Fed had correctly signaled it would not be making any big moves, but its final policy meeting of this unusual year and the last under the Trump administration was even more underwhelming than it needed to be. The Fed’s failure to tilt its bond purchases to longer maturities particularly disappointed investors.
Powell’s tepid repetition of guarantees that the Fed would use its whole tool box for years if necessary have long since been discounted by investors.
And then lawmakers quickly tempered his assurances by making some of those tools a sticking point in negotiations for fiscal stimulus. All in all, 2020 is undoubtedly a year central bankers will be glad is over.