A new role for central banks post COVID-19?

Over the last two years, the COVID-19 crisis has led to unorthodox monetary policy becoming the norm rather than the exception, a trend that may have been initiated in 2009 in responding to the global financial crisis (GFC). Central banks are now the de facto lender and market maker of last resort in a financial market ecosystem in which market-based finance has replaced traditional banking intermediation as the key channel for financing mechanisms.

Global policymakers are still debating which policy stance will lead to a successful post-crisis economic recovery. They’re busy balancing the design of potential future fiscal and monetary policy to deal with liquidity crises, global market contagion or other systemic shocks. 

Recent financial crises show that the typical maturity transformation process at the center of the intermediation that the finance industry provides to the broader economy has transformed. As such, the shift to a market-based financial system has made crises more dependent on central banks assuming the role of market maker of last resort — and only central banks have the capacity to produce the most desirable type of money to stabilize collateral asset markets and to keep the system afloat.

At the core of this dynamic, we find that understanding the inherent and implicit hierarchy of money is essential to properly interpret how crises form and propagate across the system. 

New findings from CFA Institute’s white paper on how the role of central banks in capital  markets and the economy has changed since 2008 show the COVID-19 pandemic has only exacerbated the transformation of central banks. They have become entities that act as lender and market maker of last resort, every time markets experience a level of stress that could reverberate across money markets — including credit and financial assets used as collateral. Together, the various stratums of money markets have replaced traditional banks as a supply chain for capital markets activity.

Central bankers are working through solutions to normalize monetary policy without derailing the still-frail economic recovery or market liquidity. In this, there must be consideration of the risk of runaway inflation crystallizing if the money supply is not normalized in a timely fashion.

In such circumstances, game theory may become useful in analyzing the communication quagmire between central banks and market actors, one in which central banks’ forward guidance is becoming some form of oracle whose every word is scrutinized in order to read the future. 

Policymakers are also grappling with weighing the potential solutions related to the supply side and the output gap generated by the economic lockdowns of the COVID-19 crisis. The extent to which monetary policy can have an effective impact on the economics at play in the supply chain concerns is to be determined, whereas it is possible fiscal policy and economic support measures may have had a more direct influence. Talks of a more formal coordination between fiscal and monetary policy is likely to become a key policy conundrum in the future as authorities grapple with economic and financial crises, which will inevitably bring into question the notion of central bank independence. 

One should not consider lightly a transformation of central banks’ role in the economy and capital markets. The perceived independence of these institutions was intimately linked to the belief that monetary authorities will intervene to protect trust in the sovereign currency and in the future value of financial assets. Any meaningful change to this paradigm could have structural consequences for financial stability and future macroeconomics. 

The full impact of the COVID-19 pandemic on the traditional balance of powers between fiscal policy and monetary policy, as well as the role of public authorities, has yet to be seen. But we will continue to see the use of unorthodox measures.

Olivier Fines, CFA, is head of advocacy and capital markets policy research for EMEA at CFA Institute.