Central banks and the next bubble (2)
In the previous bubble blog earlier in the week I wrote that G4 central bank balance sheets are expanding to a whopping 26% of GDP.
Swiss private bank Lombard Odier, weighing in on the debate, warns that not only has the quality of central bank balance sheets deteriorated, there has been no visible impact on the real economy.
Stephanie Kretz, member of the investment strategy team for private banking at Lombard Odier, points out that a sharp fall in the money multiplier, defined as the ratio of broad money (M3) to the monetary base, means the impact on the real economy has been almost non-existent.
What about the real economy? Ballooning and riskier central bank balance sheets will not generate sustainable growth or reduce unemployment and debt levels, but could well induce at a later stage unintended consequences that include bouts of hyper-inflation, loss of trust in fiat money and loss of central banks’ credibility as to their capacity to maintain strong currencies and stable prices.
The huge increase in the monetary base has not flowed into the real economy, and is sitting in the excess reserves of still reluctant-to-lend banks whilst the world is deleveraging, thus capping the demand for credit.
What happens when a recovery eventually kicks in, interest rates go up, the velocity of circulation of money comes back and real economy is flooded with paper currency that does not correspond to real human production? Monetary base expansion will need to be reversed in large, non-incremental steps if it is to be non-inflationary. This is uncharted territory for central banks and poses significant longer-term policy risks.