In these situations, investors have been given a put option of sorts by central banks since they have a price floor in place. For example, an investor holding shares of a broad market index may have a sort of guarantee from the central bank that the stock won’t drop below 20% since if it did, the central bank would intervene with low-interest rates to boost equity valuations. There was no actual guarantee by the central bank, but the precedent was enough for many investors.
About the Central Bank
Central banks have a number of different tools at their disposal designed to influence interest rates and thereby impact asset prices. Since the 2008 economic crisis, this tool set has expanded to include options designed to influence asset prices directly. For example, the U.S. Federal Reserve began directly purchasing mortgages and Treasurys during the economic downturn to boost the prices and liquidity of these assets during times of trouble. The most common tools used in monetary policy include:
Money Supply: Central banks can purchase government bonds to increase the money supply or sell them to reduce the money supply in what are known as open market operations. Changes in money supply, in turn, affect interbank interest rates. Interest Rates: Central banks can directly set interest rates, such as the U.S. overnight bank lending rate, to control the demand for money. Higher interest rates generally equate to less demand and vice versa for lower interest rates. Bank Reserves: Central banks can mandate the amount of money that commercial banks must hold as reserves, thereby influencing the money supply in an indirect way. Higher reserve ratios reduce the money supply and vice versa for low reserve ratios. Quantitative Easing: Central banks have increasingly resorted to directly purchasing certain assets to increase the monetary base and restore liquidity to otherwise illiquid markets, such as the market for mortgages in the U.S. in 2008 and 2009.
Moral Hazards
Central banks have historically been tasked with controlling inflation by influencing interest rates via open market operations. Many central banks have expanded their mandates to focus instead on economic growth, employment, and financial stability. Since the 2008 economic crisis, the result has been chronically low interest rates designed to stimulate economic growth and improve employment rates within many countries around the world. The problem is that these mandates may conflict with each other at times, such as how low interest rates have caused a debt bubble in many countries since companies and consumers are encouraged to take on more debt. Flooding the market with cheap cash could also become a problem when economic growth returns since the excess capital could quickly lead to inflation unless it’s properly handled by raising interest rates in a timely fashion. Central bank puts can also become a moral hazard since market participants will take on greater risks knowing the banks will incur the associated costs. For example, if a central bank implements monetary policy every time the market falls 15%, investors in the market may be willing to take on greater risk knowing that they will likely be rescued by monetary policy. And ultimately, these problems can cause instability within a marketplace.
Limits to Monetary Policy
The aftermath of the 2008 global economic crisis has also led to concerns about the limits of monetary policies’ impact on the economy. With long periods of low interest rates and bond-buying programs in place, there may be fewer measures available to central banks to stimulate the economy and provide a boost to equity prices. In particular, a key problem following the 2008 financial crisis has been an inability to spur inflation at or above the 2% target rate in the United States. The lack of inflation has many economists concerned that the economic recovery isn’t evenly spread and beneficial to everyone. For investors, this means that the long-term beneficial effects are less certain than during durable recoveries that include a healthy dose of inflation.
