The Bank for International Settlements (BIS) is in the unique position of serving global economic stability in general… and central banks in particular.
It functions as a master hub for all the world’s central banks. It settles transactions among central banks and other international organizations. It doesn’t serve private individuals, businesses, or national governments
It can, therefore, criticize central banks more freely than politicians, bankers, or business leaders can. The BIS is usually gently critical in public documents. But, their recent report ratchets up the public level of the BIS’s concerns.
Here’s the problem with current monetary policy
Right now, the problem is that monetary policy is carrying a load it was not designed to bear. Strong central bank action during the crisis was necessary, says the BIS report, but the extended wind-down hasn’t served the desired goals.
This long-term reliance on extraordinary monetary policy carries a big risk—causing the rest of us to lose faith in the policymakers. The BIS warns:
Financial markets have grown increasingly dependent on central banks’ support, and the room for policy maneuver has narrowed. Should this situation be stretched to the point of shaking public confidence in policymaking, the consequences for financial markets and the economy could be serious. Worryingly, we saw the first real signs of this happening during the market turbulence in February.
In other words, what happens when banks, investors, and the public lose trust in the Fed, the ECB, the Bank of England, and the Bank of Japan?
The BIS isn’t talking about the routine grousing we all engage in. Everyone gripes about the Fed in good times or bad. But beneath our chronic irritation, we still maintain a basic trust that the Fed will step in to prevent any disaster.
What if that’s not true? What if the Fed really is out of bullets? If you ask almost anyone connected with the Fed, they’ll tell you, it still has choices and ammunition.
The problem I worry about is, does the Fed actually have any more live bullets?
We all hope not to learn the answer to my question. The BIS drops a pretty loud hint, though. With its “Worryingly” sentence, the BIS confirms that we are right to wonder about the continued value of central bank action.
The BIS says liquidity was underpriced before the crisis
The BIS goes on to offer some policy suggestions. They group their ideas into three sections: prudential, fiscal, and monetary.
By “prudential” policy, the BIS means bank regulation and capital requirements. Much has changed on that front since the last crisis. The Basel III framework is forcing banks to hold more capital to cover the risks they take. This requirement is having the effect, according to many traders, of drastically reducing bond market liquidity.
The BIS concedes the point but responds with an argument I haven’t seen anywhere else. Before the last crisis, it says, liquidity was actually underpriced. Liquidity providers, having not been fully rewarded for the value they provide, then disappeared when everyone really needed them. Central banks and governments had to step in and take their place.
To avoid this problem in the future, the BIS says we should be happy to pay more for liquidity than we are accustomed to doing. We should pay market-makers well in good times so they will be there for us when a storm hits.
The best structural safeguard against fair-weather liquidity and its damaging power is to avoid the illusion of permanent market liquidity and to improve the resilience of financial institutions. Stronger capital and liquidity standards are not part of the problem but an essential part of the solution. Stronger market-makers mean more robust market liquidity.
I deeply suspect this language is really a veiled criticism of high-frequency algorithmic trading. High-frequency trading (HFT) creates an illusion of liquidity. Depending on whom you believe and how you measure it, HFT may be 70% or more of total market volume.
This trading will immediately disappear if we actually need liquidity. It is simply a scam by exchanges and funds that use HFT to say that these entities are providers of liquidity. HFT is precisely what the BIS is talking about when they use the term illusion of market liquidity.
It makes me wonder if we are going to miss the “specialist” role the NYSE has traditionally had for the trading of most listed stocks. The exchange has nearly done away with all that and thought it could make up for the lost fairness and market equilibrium with volume. I’m not sure it has worked out that way.
In the fiscal policy area, the BIS says we should rethink how we evaluate sovereign risk. Because governments—or at least the ones that have their own currency—can always “print money,” investors assume their credit risk is low or nonexistent.
That’s clearly not the case. Ask someone who invested in Argentine government bonds a few years ago, and they will explain. Whatever governments deliver in reduced credit risk is usually offset by more inflation and interest-rate or market risks.
We need to think about risk as a liquid substance. We can move it from one bottle to another, split it among multiple bottles, or put it in the deep freeze. But we can’t make it disappear. Even pouring it down the drain just transfers it to someone else.
If prudential and fiscal policies were properly organized, we would not need to rely on central banks so much. But that doesn’t mean central banks should be inactive. The BIS does openly argue for a strong monetary policy role. However, it thinks that role should look different than it does today.
Here’s what central banks should do
One big change BIS suggests is to rely less on inflation targeting. Stubbornly low inflation is what has kept policy accommodative ever since the 2008 crisis. In hindsight, it may have been better to tighten interest rates back toward “normal” (whatever that is) long before inflation rose back to “normal” (whatever that is).
It’s hard to say how this approach would have worked in practice. By 2011, the US was out of recession and stocks were doing well, but unemployment was still stubbornly high. Unable to drop rates any further, the Fed launched quantitative easing instead. The ECB is now doing something similar but even more aggressively.
For three or four years, the Federal Reserve used the excuse that unemployment was unacceptably high. But then, when unemployment got close to the “normal” range, it simply refused to pull the rate-hike trigger.
The Fed worries more about stock markets than the imbalances it is creating. It is in danger of losing credibility. And that’s damaging to all of us.
One way or another, says the BIS, “We badly need policies that we will not once again regret when the future becomes today.”
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