The financial markets are becoming ever more dependent on the continuing willingness of the central banks to use their balance sheets to rescue the global economy. The central banks are not flinching from their task. In fact, they are in the process of firing their second barrel of quantitative easing at the global crisis. It could prove to be as large as the first barrel in 2008/09.
The dependence of the markets on the central banks is, of course, nothing new. But nor has it ever been greater than it is now. At the time of the 2008/09 crisis, the provision of unprecedented amounts of liquidity by all of the central banks to the financial sector was an essential component of the policy response which stabilised the crisis. And the precipitous cuts in interest rates which followed, along with the first experiments in quantitative easing, helped the global economy to recover in 2009/10.
But at that time the central banks were not acting alone. Governments also used their balance sheets to cushion the depth of the recession, as the private sectors took urgent steps to reduce debt. Now, governments are trying to reduce the growth of their balance sheets by tightening fiscal policy, leaving the central banks as the only remaining actor in the rescue operation.
The scale of recent central bank action is extraordinary, by any historic standard other than that of late 2008. The first graph shows what the major developed central banks have been doing recently, and makes some assumptions about what they may do next.
At the Fed, there has been no increase in the size of its balance sheet since QE2 ended in July, but Operation Twist started in September. This is commonly estimated to have the same impact on monetary conditions as QE2 had via an increase in the balance sheet.
In the graph, the low estimate for the Fed makes no allowance for Operation Twist, and assumes that there will be no announcement of QE3 in the first half of next year. The high estimate assumes that Operation Twist is the equivalent of a $600 billion increase in the balance sheet. Alternatively, the result would be the same if we make no allowance for Operation Twist, but assume that the Fed’s new program of dollar swaps turn out to be worth $300 billion, and that the Fed also undertakes purchases of mortgage securities worth $300 billion in the first half of next year.
For the ECB, I assume that the rate of expansion in the balance sheet which has been observed since early August is broadly maintained up to mid 2012. This might prove to be too conservative, given the scale of the liquidity injections announced last week, and the possibility that the size of bond purchases under the SMP may be stepped up following the fiscal compact reached at the latest summit. Of course, we can expect the ECB to deflect attention away from the growth of its balance sheet by claiming that the impact on monetary conditions is being sterilised, but this is not very convincing. Only if the Bundesbank throws its body across the tracks will the estimates in the graph prove markedly too high.
At the Bank of England (always the prime enthusiasts for quantitative easing), I have assumed that the current £75 billion program of gilt purchases is completed by February, and that an identical further program is then implemented between February and June. This assumes that the economy achieves no growth between now and mid 2012, and that headline inflation soon starts to fall very rapidly. For the Bank of Japan, which is the laggard among the major central banks when it comes to QE, I have assumed that the slow rate of increase in its balance sheet since mid-2010 will be maintained over the coming 6 months.
All of this would amount to an enormous further increase in the overall size of central bank balance sheets. The second graph shows that the scale of this second episode of QE could rival that of the first episode in 2008/09. The calculation shows the 12-month change in the total central bank balance sheet for the four main developed economies, weighted by shares in GDP and expressed as a percentage of the normal size of these balance sheets before 2008. This method of calculation enables us to compare the size of the two monetary injections more meaningfully than the simple percentage increase in the balance sheet.
On the high estimate for Fed easing, which seems the more relevant of the two estimates, the 12 month global injection will, by mid 2012, be similar in scale to the post-Lehman injection. On the lower estimate for the Fed, which gives no weight to Operation Twist, and which assumes no further round of QE from the Fed, the overall global monetary injection will be about half as large as in 2008/09.
Either way, it is clear that central bank balance sheets will have increased in a completely unprecedented manner from 2008 to 2012, unless we count previous episodes of hyper-inflation, such as the German experience in 1923. The rise in the balance sheets of the big four central banks over the 2008-12 period will amount to about 15 per cent of GDP, which is equivalent to over 50 per cent of the cumulative budget deficit of these countries over the same period. Who knows what would have happened to bond yields in the absence of this action.
Because this behaviour is so unprecedented, it is hard to predict the medium term consequences of such a massive dose of QE. Many economists argue that, in the absence of any rise in inflation expectations, central bank balance sheets are in effect infinitely large, and can be used as needed to combat the crisis.
Given the outsize scale of what the central banks are now doing, this argument needs increasingly careful examination. But one conclusion already seems clear. If this strategy does not work, there will be little else left in the locker of the emergency services.
Copyright The Financial Times Limited 2011.