SERIOUS MONEY:The timing of the withdrawal of monetary stimulus will have a big impact on investors

THE GOLDEN age of central banking is over. The greater price and economic stability that accompanied the “Great Moderation” during the 1990s contributed to increased financial fragility below the surface, as investors, lenders and speculators overlooked risk in their search for higher returns.

The gravitation from hedge to speculative finance, and inevitably to Ponzi finance, placed the global financial system at considerable risk and the eventual implosion necessitated record monetary stimulus by the world’s central banks in order to prevent a meltdown and repeat of the Great Depression. The gargantuan expansion of central bank balance sheets has been successful in thwarting the worst-case scenario and the global economy is now in early recovery.

Complacency, however, is ill-advised as the design and timing of an eventual exit strategy is attracting increasing scrutiny by the day. The task should not be underestimated as an early withdrawal of stimulus could precipitate a 1937-style depression while a late withdrawal could unhinge stable inflation expectations and cause a 1970s-style stagflation.

The tumultuous events of the last two years have witnessed a gargantuan expansion of central bank balance sheets. The consolidated assets of the US Federal Reserve more than doubled from the onset of the crisis through the summer of this year, the Bank of England’s balance sheet almost tripled over the same period and, in both cases, total assets reached some 15 per cent of GDP. The Eurosystem’s balance sheet jumped by 50 per cent to roughly 20 per cent of GDP, while the assets of the Bank of Japan grew by about 25 per cent and amounted to 22 per cent of GDP in August. The figures, however, dramatically underestimate the concomitant increased role of central banks in financial markets, particularly the Federal Reserve, which has been transformed from a monetary authority with a minimal role in credit intermediation to a highly-leveraged market-maker with its underlying capital base at risk.

The structure of the Federal Reserve’s balance sheet was little changed in the more than a half-century that followed the US Treasury-Federal Reserve Accord of 1951, which ended the central bank’s commitment to peg interest rates on treasury debt and re-established the Fed’s control over its balance sheet and monetary assets. The size of the Fed’s balance sheet dropped relative to GDP from 1951 onwards; it dropped below 10 per cent in the early 1960s and hovered about 6 per cent from the early 1980s to the end of 2006.

Balance sheet growth was determined primarily by the secular increase in the demand for US dollar banknotes, whose issue was accompanied by the occasional outright purchase of treasury securities in the secondary market. The holdings of treasury securities and banknotes in circulation accounted for roughly 90 per cent of the asset- and liability-sides of the balance sheet.

The Fed’s balance sheet played a minimal role in credit intermediation and monetary policy assets including liquidity-providing repurchase agreements and loans to depositary institutions rarely accounted for more than half a percentage point of GDP.

The outbreak of the financial crisis in 2007 and its continued deterioration throughout 2008 prompted the Fed to respond in unique and unconventional ways that saw the size of its balance sheet jump from $870 billion at year-end 2006 to $2.2 trillion two years later. The alphabet soup of special facilities introduced saw monetary policy assets soar by roughly 4,000 per cent to almost 12 per cent of GDP and caused a dramatic deterioration in the composition of assets as the Fed actively intermediated in distressed credit markets and targeted relative prices across different instruments and maturities.

The balance sheet’s compositional change places the Federal Reserve’s capital at risk, which could potentially undermine the central bank’s independence should it require a capital injection, though such an outcome could be avoided through a revaluation of its gold holdings.

Though undoubtedly a sentiment issue, it is the evolution of the liability-side of the balance sheet that is likely to be the primary market focus going forward. The explosive growth in Fed assets has been accompanied by a surge in excess commercial bank reserves, which have surged from less than $2 billion at end-2006 to roughly $1 trillion in recent weeks and look set to reach $1.2 trillion early next year, reflecting the ongoing impact of large-scale asset purchases as well as the wind-down of the treasury’s supplemental financing programme.

The extraordinarily high level of excess reserves could prove highly inflationary should the banks decide to lend and it’s clear the Fed would be unable to undo the exceptional monetary stimulus in a hurry should it need to do so.

Various options are available including reverse repurchase agreements, higher interest rates on reserves, term deposits and asset sales. The Fed, however, is moving into uncharted territory and the first four options would all amount to no more than a temporary solution and in some cases be difficult to execute, while the last could easily precipitate market disorder as traders attempted to front-run the Fed.

The withdrawal of monetary stimulus is likely to increasingly concern investors in the months ahead, though the Fed has time on its side with the output gap at close to 10 per cent of GDP exerting significant deflationary pressures, and should it act now, it would surely be as grave a mistake as that committed by its predecessors in 1936.

Excessive liquidity, however, has already seen asset prices move far ahead of economic reality and currencies, particularly the US dollar, fall prey to speculative carry trades.

Central banks in the east have taken the lead with China announcing a sizeable increase in its gold holdings earlier in the year with India and Sri Lanka following on their coat-tails. It is clear that should the Fed act either too early or too late, precious metals are the place to be.

charliefell@sequoia.ie