Central banks have been creating money since the Covid-19 crisis: inflation is inevitable, but which one exactly? Continued rise in financial assets or soaring prices for goods and services?
We hear a lot these days about “spinning the money printing”, or massive monetization. It is quite simply the phenomenon of monetary creation by a central bank.
In reality, monetary creation ex nihilo represents a debt that the central bank issues on itself and which, in fact, unlike any liability, is not due and repayable – in any case except for exceptional historical circumstances which would imply that the currency issued is no longer accepted as as a means of exchange and store of value (hyperinflation and flight from money).
Balance sheet of central banks: a little reminder …
Monetary creation is therefore a liability of the central bank’s balance sheet (in this liability, we must add the minimum reserves constituted by the banks and especially the cash deposited by these same banks with the central bank to constitute their liquidity reserve imposed by Basel regulations).
In front of this liability, there are the active from the central bank (receivables, whatever the central bank lends and buys).
The ECB is the lender of last resort to the banks, through all conventional and unconventional refinancing operations. These are for example TLTROs (for Targeted Long Term Refinancing Operations), considered as unconventional operations but which tend to become the norm since they have been almost “institutionalized” since 2014.
The ECB is also a buyer of securities in the financial markets – mainly government bonds through asset buyback programs since 2015, commonly known as quantitative easings or quantitative easing.
Below is a simplified balance sheet of the European Central Bank (the structure of this balance sheet could be that of any other central bank).
As lender as a last resort, the issuing institution allocates the liquidity resulting from monetary creation to the banks.
As’Buyer as a last resort, the issuing institution allocates the liquidity resulting from monetary creation to the financial markets, that is to say to the sellers of the securities bought by the central bank (therefore the banks but also the insurers, the funds of pension and other institutional investors…).
How is central bank liquidity used?
How is this liquidity used by banks through these conventional and unconventional refinancing operations?
First use: banks can clean up their liabilities by lowering their average cost. It is then a question of repaying the costly debt by means of new resources raised at increasingly low rates in a context of continuous fall in the cost of money for 10 years.
Second use: the fact that banks store the liquidity received (and therefore not use it) in their current cash account for risk aversion reasons, or in their deposit account (excess reserves) at the central bank for regulatory reasons as part of the management of the liquidity reserve (this is the LCR ratio, i.e. Liquidity Coverage Ratio).
Third use: banks can invest in financial markets by often buying assets with their eyes closed, which self-sustains bubbles in different segments – real estate, equities, covered bonds, obligations corporate, government bonds.
Finally, fourth use: the financing of the so-called real economy, a use which must have seemed the most natural and which led to the creation of the TLTROs – hence the T of targeted, “Targeted”. This allows the central bank to target and condition the allocation of liquidity to the various banks on the growth of outstanding loans to businesses.
Regarding the liquidity received by financial market players who sell bonds to the central bank, it is clear that this will be reused almost entirely on the financial markets, often leading to accelerate the disconnection between the price of certain financial assets and the fundamentals of those assets. We can thus better understand the inflation of financial assets (another way of speaking of asset bubbles).
But then how to understand the absence of inflation in the sphere of the real economy so far, despite this extraordinary growth in the central bank’s balance sheet (what is called the monetary base and which depends on the creation of change ex nihilo)?
Since the impact of the Covid crisis on the financial markets began in March 2020, the monetization (money creation) by central banks has consisted in buying all the public debts issued and therefore in financing the explosion of public deficits to compensate for the decline in national GDP.
This financing of spending increases and deferral of tax revenues could not trigger traditional inflation in the real economy since it took place in a context of offsetting the fall in activity.
What scenarios for 2021… and after?
Three economic scenarios are possible:
First scenario : a normalization of the health situation and a strong recovery in the economic cycle with the maintenance of an accommodating monetary policy.
In this scenario, the uncertainty of economic agents decreases significantly but monetary policies remain accommodating with an abundant money supply. This means that a significant part of the money held by private economic agents is consumed and invested, which would be the start of an inflationary period in the sphere of goods and services.
As the money supply remains excessive, we do not observe a fall in asset prices (stocks, bonds) but the rise is over : equities are no longer rising (a global approach that does not call into question bets on certain sectors, certain geographic areas, certain management styles or certain stocks).
Probability of this scenario: 20%
Second scenario : a normalization of the health situation and a strong recovery in the economic cycle with an evolution of the forward guidance central banks.
This scenario makes the financial markets anticipate – rightly or wrongly – the beginning of a less accommodative monetary policy outline: reduction of asset buyback programs for the less “pessimistic”; end of asset buyback programs for the most pessimistic; one cannot imagine for a single moment a normalization of monetary policy with a drop in the size of central banks’ balance sheets and therefore in asset sales.
In this scenario, we would then see the transition from inflation of financial assets to that of inflation itself.
We would then be in full paradox with the end of the “bad news (for the economy) = good news (for the markets)” which has fed the markets for 10 years. It resulted in a rise in the stock markets all the more important as the economic news was disastrous and that it was then expected more and more injections of liquidity by the central banks … which liquidity would often be invested indiscriminately in the markets.
It would then be, ironically, the start of “good news (for the economy) = bad news (for the markets)” which would cause the stock markets to fall sharply. This fall is all the more important when the economic news is very good and when restrictive monetary policies and therefore less and less liquidity to invest in the markets are expected.
What a paradox all the same: stock markets that rose in times of economic pessimism and stock markets that would decline in times of economic optimism. Some would say that the function of markets is to anticipate. It should be noted that there is no longer any question of anticipations in this context but quite simply of disconnecting the economy from the markets via the liquidity factor.
Probability of this scenario: 40%
Third scenario : no normalization of the health situation in 2021.
In this scenario, it is excluded to anticipate a return of inflation in the sphere of the real economy since households and companies would remain wait-and-see and the excessive private savings consequent.
Should we then expect, as in 2020, a continuation of monetary expansionism and therefore the continuation of inflation of financial assets (and therefore asset bubbles as delusional as they are indecent)?
We do not think so and we are counting on central bank fatigue. We believe that the relay will now be provided by economic policies of direct aid to the economy and less and less by monetary policies consisting in providing liquidity to banks and financial markets.
The first announcements from the Biden administration point in this direction:
– $ 400 billion in measures targeted to the Covid crisis: national vaccination program, acceleration of tests;
– $ 1,000 billion in direct aid to households (checks for $ 2,000, extension of unemployment insurance, food aid);
– $ 440 billion in direct aid to small businesses.
Probability of this scenario: 40%
Monetary creation will undoubtedly ultimately take the form of “helicopter money” more in the future than the form of the devices that we have known since 2009: unconventional refinancing of banks; asset buyback policies (quantitative easing).
Whatever the scenario envisaged, we feel that the inflation of financial assets has lived and that the inflation of goods and services is ahead of us.
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