FRANKFURT — The chickens are finally coming home to roost for central banks.
For years, they were hailed as saviors of the global financial system, credited with keeping the economy going, banks afloat and helping governments to avoid defaulting on their bonds.
But as inflation batters western economies, central banks face a crisis of credibility as their most potent policy tool — interest rates — struggles to tame inflation. Rising interest rates, in turn, are vaporizing the value of the government bonds they bought en masse, saddling central banks with huge losses.
According to a tally of registered and upcoming losses, key central banks including the European Central Bank, the U.S. Federal Reserve, the Bank of England, the Swiss National Bank and the Australian central bank now face potential losses of more than $1 trillion collectively, as once-profitable bonds turn into liabilities.
“In hindsight, it is clear that central banks’ massive bond-buying programs were a colossal mistake,” said Daniel Gros, an economist and board member of the Centre for European Policy Studies.
The danger for central banks isn’t that they will go bankrupt or lose their policymaking powers.
It’s that they will look so weak that politicians will feel entitled to attack them — as is already the case in Europe where French President Emmanuel Macron and other leaders have urged ECB chief Christine Lagarde to slow the pace of her interest rate hikes to facilitate growth.
“Central banks are already under a lot of pressure from their populace and also their political counterparts in government for not having brought down inflation as quickly as they hoped,” said Derek Tang, an economist at research firm LH Meyer Monetary Policy Analytics. “There has already been an erosion of trust and faith in some of these central banks. Now, the capital loss scenarios add another difficult layer on top of that.”
Dizzying losses
To understand how central banks got to this point, it helps to review some of their major policy moves of the past decade.
In a bid to spur growth and inflation, central banks slashed interest rates to record lows. Once rates approached zero, they pushed down long-term interest rates by using a popular tool, so-called quantitative easing, under which central banks bought trillions worth of government debt to further drive down long-term borrowing costs.
Now, the rising interest rates are rapidly eroding the value of bonds central banks bought over the last decade.
Another popular tool was to lend money to banks at ultra-low rates for extra-long periods to spur lending to the real economy. But rising rates mean that banks that holds cheap central bank funds and can earn windfall profits simply by parking funds at the central bank overnight.
So the bitter irony is that these same moves, once hailed as salutary, are now coming back to haunt the central banks.
The largest central bank loss announced so far is from the Swiss National Bank, which posted a loss of 142 billion Swiss francs for the first nine months of the year, equivalent to more than 15 percent of the country’s gross domestic product.
In Australia, losses of 36.7 billion Australian dollars have wiped out the central bank’s capital reserves.
In the United States, the Federal Reserve’s income has turned negative and payments to the U.S. Treasury have been stopped. A Fed research paper published in July said the central bank would likely operate under a loss for three to four years and book a $60 billion deferred asset.
But according to Tang, the Fed’s losses are likely to end up being closer to $100 billion.
The Bank of England last month reported a loss from its bond holdings. With losses set to mount, the government promised to transfer more than £11 billion this fiscal year to the central bank. The Office for Budget Responsibility said that “through 2028 the Treasury pays £133 billion to cover these losses, more than reversing the previous 13 years’ gains.”
The ECB has not put any numbers on expected losses yet, but a senior ECB official, Ulrich Bindseil, said things are not looking in great in Frankfurt either.
“It is not rocket science to see there is a potential loss going forward,” he said in a recent podcast with Natixis. “I think it’s clear that we don’t face very good years.”
Just how much remains to be seen. But for Gros, the Eurosystem consisting of the ECB and the eurozone’s national central banks could end up facing €600 billion in losses from its asset purchases over the next nine years if the interest rate rises to 3 percent and the ECB doesn’t actively sell bonds.
That is roughly twice as much as they have made in profits over the past 10 years, according to data provided by the central bank.
An ECB spokesperson said its pockets are deep enough to withstand potential shortfalls.
These losses won’t immediately impede central banks’ ability to conduct monetary policy. But they could expose them to political pressures and over time erode their focus on price stability, analysts warn.
If a central bank suffers large losses and may feel the need to go cap in hand to its government to request recapitalization, it could face “increasing political pressure on it to undertake quasi-fiscal activities or possibly increasing its willingness to tolerate higher inflation to rebuild capital through seigniorage, potentially influencing its policy credibility,” said Fitch chief economist Brian Coulton.
Tang added that in the United States, irrespective of the Fed’s warning, budget documents from the US Congress assume that the Treasury will still receive money from the Federal Reserve.
“There’s a discrepancy there, that needs to be reconciled. I think that’s the political risk, that there’s money that they’re expecting, but they’re not going to receive.”
Eurozone complications
As so often, things are even more complicated in the eurozone.
Only part of assets bought are held on the ECB’s balance sheet, but the lion’s share of risks stemming from the quantitative easing programs rests with national central banks.
Ironically, national central banks of the most fiscally prudent EU countries — that were the most skeptical of asset purchases — will incur the biggest losses, as the bonds they bought under the ECB’s quantitative easing programs yield zero or less.
Germany’s Bundesbank has already halted transfer of profits to Berlin two years ago, while the central banks of Belgium and the Netherlands have already flagged losses for this year.
What central banks need now is good communication, Tang argued.
“The losses are obviously not desirable, but they are a consequence of the fact that they’ve had to take monetary policy measures which are justified,” he said.
And while the Fed may be losing money now, it has earned the taxpayer a lot of money and is expected to do so again in future. “I think those are some things to keep in mind.”
Gros hopes that central bankers will learn a lesson.
“The next time they use unconventional policy instruments with major fiscal implications, they should be far more explicit about the risks – and far more cautious about taking them,” said Gros.
Victoria Guida contributed reporting.