Past masters
The future looks tougher for central banks
There’s never a good time for inflation if you are central banker. But this bout of inflation has come at a bad time. Not only are price rises partially a supply-side issue, for which central banks have little remedy, but inflation coincides with unwelcome news on their own balance sheets. For decades it seemed that whatever liquidity largesse central banks threw at their economies, inflation remained quiescent. QE seemed free of consequence, and balance sheets expanded. No longer.
Now inflation is a major societal issue and central banks are attempting to reduce their balance sheets. How they deal with the twin issues of inflation and QT may influence how society views them. Do they deliver welfare benefits for all? Or will they be remembered chiefly for the asset price gains caused by expanded balance sheets; a gift for the wealthy ultimately socialised via inflation for everyone else? No longer Masters of the Universe. It seems a good bet that one accusation central bankers will wish to avoid for the time being is that they are too sensitive to asset prices declines.
Take the Fed, the most transparent of all central banks. The average price of bonds bought by the Fed was well above face-value. This loss difference in price appears in their balance sheet as ‘unamortized premiums/discounts’. When divided by the total stock of Securities it suggests the Fed paid approximately 6% over par on its Treasury portfolio.
To date, this difference was slowly amortized by an excess of coupon income over funding cost of Interest on Excess Reserves (IOR). But that route looks challenged. Fed Funds rates soon may rise to a level that exceeds the coupon income. Then the QE portfolio will generate an income loss in addition to the face-value loss from buying above par.
In theory, the government could return some of the extraordinary profits it has garnered from the Fed in the last 10 years to fill the hole. In practice, it seems much more likely the Fed will deal with the problem itself. There are suggestions in a recent Bloomberg article that the Fed will classify the loss as a ‘deferred asset which it (the Fed) will then have to make up through future earnings.” Inevitably, this will reduce Fed transfers to the Federal government.
To fund the ‘unamortized premium/discount’, the Fed needs the cost of its liabilities to fall below the coupon stream or a diversion of profits from seignorage. Which is where it gets interesting. Too much emphasis on containing funding costs risk suggestions that monetary policy has been diverted from fighting inflation. Similarly, too much emphasis on seignorage will risk accusations of stoking, rather than restraining inflation from increasing money supply. On top of that if they take too long to solve the issue they risk accusations of debt monetisation. Concern about asset prices will come some way down the list of worries. And whatever happens, central bankers seem destined to lose friends.