Walking the tightrope: what will happen when central banks retreat
Euromoney, is part of the Delinian Group, Delinian Limited, 4 Bouverie Street, London, EC4Y 8AX, Registered in England & Wales, Company number 00954730
Copyright © Delinian Limited and its affiliated companies 2024
Accessibility | Terms of Use | Privacy Policy | Modern Slavery Statement
Sponsored Content

Walking the tightrope: what will happen when central banks retreat

Central banks’ imminent retreat from the unprecedented monetary easing adopted following the financial crisis could lead to a severe loss of confidence in the markets, economic contraction and deflation — not just inflation as many fear. Sherif Lotfi, Head of Corporate Advisory, Americas, and Edward B. Marrinan, Head of US Macro Credit Strategy and Co-Head, Markets Strategy, Americas, at RBS explain.

The range of monetary easing programs introduced around the world since 2008 has led to intended and unintended distortion across the financial markets and wider economy. What was originally designed as an unconventional and temporary response to spur economic activity has become a protracted monetary policy for developed economies.

We have seen low demand for loans and regulatory pressure on banks to hold more capital and liquidity. This means the extra cash pumped into the system when central banks bought troves of securities has ended up back with the central banks as excess reserves — failing to filter through to the wider economy.

Monetary easing has not had the full effect the central banks hoped for – their actions have been akin to sprinting hip deep in mud.

Alongside quantitative easing (QE), monetary easing policies include lowering benchmark rates to nearly zero – known as ZIRP (Zero Interest Rate Policy), providing various liquidity programs targeted at specific markets and adding interest on reserves.

QE was designed to push investors away from cash or government bonds and toward private sector capital – loans, bonds and equities. While the central banks have lifted the value of these so-called ‘risk assets’ by lowering base rates to offset unusually high risk premiums, their actions carry significant risk too.

Potential consequences include a credit bubble, commodity price volatility and currency wars. Meanwhile, the yield compression created by QE is herding retail investors toward a new crisis when rates inevitably rise – unless the central banks can navigate the exit without an asset collapse or rapid inflation. It’s like walking a tightrope across the Grand Canyon.

The longer such policies remain, the more distortive they become. Central banks’ ability to retreat successfully as the economy heals depends on how well banks can deploy their balance sheets, the influence of demography and technology, and the extent to which new regulation inhibits cross-border capital flows.

There are three potential outcomes.

Successfully walk the tightrope

Since many of the assets they purchased are relatively short duration, central banks do not have to sell a huge portion of their securities to absorb excess money as the economy recovers. They can allow assets to run off and manage liquidity as banks deploy, using their excess reserves as the economy heals.

Fall off the tightrope at the beginning

A fragile recovery is laid to waste by anticipated interest rate increases from a sudden bursting of the fixed income asset bubble, economic contraction and deflation. We see either a severe loss of confidence that central banks’ unconventional policies cannot overcome, or an over-contraction in monetary policy in response to rising inflation.

Fall off the tightrope at the end

The economy heals much quicker than anticipated and the central banks are not able to reduce the excess money supply fast enough without a severe shock. We end up in a period of prolonged inflation which erodes the value of long duration assets and liabilities, reduces margins and increases volatility.

The first scenario is highly optimistic. Falling off the tightrope would put us in a prolonged period of negative or stagnant real return on all asset classes. Long-term fixed assets would obviously get hit harder with higher inflation.

Lower real asset returns will slow real consumption growth – a price we will all pay for the excesses of the past.

Companies need to consider this uncertain future when positioning their balance sheets. This means addressing additional factors. Can they pass some of their cost inflation to customers? How flexible is their cost structure? Is their industry open to further consolidation? Are there acquisitions which can enhance their technology base or expand their customer offering?

Given the breadth of corporate business models and range of potential macroeconomic outcomes, there is no one-size-fits-all response, yet most companies can benefit from more flexible balance sheets.

For example, a cyclical manufacturer’s capital expenditures are large and lumpy with demand based on global GDP and derived from spending on capital goods. The manufacturer will need substantially more flexibility than a consumer goods company which has more modest and adjustable capital expenditures despite facing a very competitive environment.

The consumer goods company will need flexibility to handle margin erosion while still investing in brands, product development and opportunities to acquire brands from those challenged to invest during a contraction.

A natural resource company faces commodity price cycles which can be volatile, as well as less cyclical production costs. It needs sufficient flexibility to manage the heightened risks from over-expansion, which are magnified by macro-uncertainty. At the same time, the company would benefit from the ability to acquire properties during contraction or before an inflationary period but manage exploitation to more profitable portions in the cycle.

Whatever the company or sector, it is difficult to over-estimate the impact pulling the plug on monetary easing will have on the economy. Businesses need to think carefully about the possible outcomes, and what effect they will have, and prepare accordingly. 

For more RBS Insight content, click here

Disclaimer

No representation, warranty, or assurance of any kind, express or implied, is made as to the accuracy or completeness of the information contained in this document and no member of the RBS Group accepts any obligation to any recipient to update or correct any information contained herein. The information in this document is published for information purposes only and does not constitute an analysis of all potentially material issues. Views expressed herein are not intended to be and should not be viewed as advice or as a recommendation. You should take independent advice in respect of issues that are of concern to you.

This document does not constitute an offer to buy or sell any investment, and nor does it constitute an offer to provide any products or services that is capable of acceptance to form a contract. The products and services described in this document may be provided by any member of the RBS Group, subject to signing appropriate contractual documentation. No member of RBS shall be liable for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including lost profits arising in any way from the information contained in this communication.

In the UK the Royal Bank of Scotland plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority, in Hong Kong by the Hong Kong Monetary Authority, in Singapore by the Monetary Authority of Singapore, in Japan by the Financial Services Agency of Japan, in Australia by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority ABN 30 101 464 528 (AFS Licence No. 241114) and in the US, by the New York State Banking Department and the Federal Reserve Board. The financial instruments described in this document are made in compliance with an applicable exemption from the registration requirements of the United States Securities Act of 1933, as amended. In the United States, securities activities are undertaken by RBS Securities Inc., which is a FINRA/SIPC (www.sipc.org) member and subsidiary of The Royal Bank of Scotland Group plc. Dubai International Financial Centre: This material has been prepared by The Royal Bank of Scotland plc and is directed at “Professional Clients” as defined by the Dubai Financial Services Authority (DF SA). No other person should act upon it. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Professional Client”. This document has not been reviewed or approved by the DF SA. Qatar Financial Centre: This material has been prepared by The Royal Bank of Scotland N.V. and is directed solely at persons who are not “Retail Customer” as defined by the Qatar Financial Centre Regulatory Authority. The financial products and services to which the material relates will only be made available to customers who satisfy the requirements of a “Business Customer” or “Market Counterparty”.

The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB. The Royal Bank of Scotland N.V is authorised by De Nederlansche Bank (DN B) and is regulated by the Autoriteit Financiele Markten (AFM) for the conduct of business in the Netherlands. The Royal Bank of Scotland plc is in certain jurisdictions an authorised agent of The Royal Bank of Scotland N.V. and The Royal Bank of Scotland N.V. is in certain jurisdictions an authorised agent of The Royal Bank of Scotland plc.

Copyright 2013 RBS. All rights reserved. This communication is for the use of intended recipients only and the contents may not be reproduced, redistributed, or copied in whole or in part for any purpose without RBS’s prior express consent

The DAISY Device logo, RBS, THE ROYAL BANK OF SCOTLAND and BUILDING TOMORROW are trade marks of The Royal Bank of Scotland Group plc

Gift this article