[Lee Jong-woo's Economic Reading] The Central Bank, Once at the Heart of the Market, Faces Shifting Position

Fed, Controversy Over Excessive Market Intervention
Low Interest Rate Policy Cannot Solve Everything
Asset Bubble Worsening Also a Problem

How far do the power and role of central banks extend? This question has recently arisen in the United States. The discussion began when former Republican Congressman Ron Paul criticized the Federal Reserve's (Fed) interest rate cuts as measures detached from capitalism. He defined the current Fed policy as an "interventionist" action and mentioned, "This will truly motivate socialists to intervene." Veteran Wall Street investor Richard Bernstein also pointed out that the Fed's interest rate cuts and excessive market intervention have inflated bubbles and led to resource allocation to zombie companies, exacerbating moral hazard.

Such criticism is understandable given the recent behavior of the Fed and other central banks worldwide. On the 11th, when the U.S. stock market dropped more than 5%, the Fed announced the possibility of expanding individual corporate bond purchases the next day. Although stock prices recovered within three days, this action sparked criticism about whether it is appropriate for a central bank to intervene so frequently in the market. The Fed's corporate bond purchases were announced in March as part of economic stimulus measures. As the risk of default increased for companies with low credit due to the novel coronavirus infection (COVID-19), the Fed announced it would deploy $600 billion to purchase corporate bonds; however, the amount executed so far is only $428 million, less than 0.1% of the planned amount. In this context, when the possibility of corporate bond purchases was brought up again, complaints arose that the Fed talks but does not act.

Criticism of the Fed has evolved into a debate over whether interest rate cuts are an appropriate policy. Advanced country central banks have maintained low interest rate policies for over 11 years but have failed to restore the economy to its proper state. Instead, a problem of weakened self-sustainability has emerged. As companies and households have become accustomed to low interest rates, the economy has reached a state where it cannot recover on its own without extreme policies such as zero percent interest rates and massive liquidity supply. Because material support has been broadly extended even to companies with weak competitiveness, these companies have sometimes become obstacles to economic recovery. Therefore, opinions have emerged that, just as creditors including the International Monetary Fund (IMF) impose harsh adjustments when crises occur in emerging countries, advanced countries should also clearly define support targets.

Interest rate cuts have also been criticized for intensifying asset price inflation. Despite the rate cuts, the intended economic recovery has not been achieved, while asset prices such as real estate and stocks have risen, resulting in a state where inflation and deflation coexist within the same economy. In this situation, it is difficult to align policy direction to either side, and if the asset price bubble bursts, the shock will be far greater than during the financial crisis. During the financial crisis, only real estate prices were inflated, but now prices of real estate, stocks, and bonds have all risen significantly, potentially causing simultaneous problems across multiple asset classes.

With the interest rate cuts and quantitative easing implemented in March, the cards that central banks can play have been exhausted. The situations of the Fed and the Bank of Korea are similar. There are calls in the U.S. to lower interest rates into negative territory, but considering the damage to financial institution soundness and the lack of significant success in countries like Japan and Europe that first implemented negative interest rates, the possibility is slim. Given that the Korean won is not an international currency, it is also difficult for the Bank of Korea to lower the base rate below 0.5%. Therefore, expectations are rising that the Fed will introduce a policy to control market interest rates from rising above a certain level for the first time since 1941, but this also presents many challenges. If such a policy is used, the Fed would have to continuously purchase government bonds whenever market interest rates exceed the target range. Considering the damage to the market's price discovery function and the consequences of not implementing the policy if bond purchases are halted and rates surge, this is not an easy task.

At the beginning of the year, the market had faith in two "Supermen." One was the political leaders of advanced countries, with Donald Trump as a representative figure. Since there is an election this year, there was a belief that the U.S. economy would continue to expand and stock prices would remain stable. Thanks to this, it was expected that there would be no serious adverse events until November, but the actual situation is moving differently from expectations. The 2000 IT bubble burst in the year of the U.S. presidential election. The incumbent party candidate Al Gore had pledged to build an IT network across the U.S., so there was a need to maintain IT company stock prices, but this was unsuccessful. The 2008 U.S. financial crisis occurred two months before the presidential election. The Bush administration submitted an emergency economic relief plan to the House, but it was rejected due to opposition from the ruling Republican Party, which argued that bailing out companies with taxpayer money was incompatible with American-style capitalism. Eventually, with the help of the opposition Democratic Party, the plan was passed, but this incident showed how naive it was to expect the election to determine the economy.

The other "Superman" was the central banks of major countries, with the Fed as the representative. Over the past 11 years, whenever the economy and stock market faced difficulties, the Fed lowered interest rates and injected liquidity to defend stock prices, so it was natural to have faith in them. The problem is that after using extreme policies for a long time, there are no more policies left to use. Coordination among central banks is also weaker than during the financial crisis. Some places, like Europe, have already exhausted their policy leeway, while China, despite actively helping during the financial crisis, is now resentful because it has applied pressure through trade disputes as the situation improved. Whatever the reason, it is difficult to expect the kind of unified response seen 10 years ago.

There is a Wall Street saying: "Don't fight the central bank." It means that since central banks have the power to raise and lower interest rates, it is better to invest in line with their policies. While this is true, the problem now is that expectations for the Fed are excessively high. When a financial crisis occurred in the U.S., former Fed Chairman Alan Greenspan harshly criticized then-Chairman Ben Bernanke, blaming him for mismanaging policies that led to the crisis. Although much of the crisis's cause was Greenspan himself lowering the base rate to 1.0% after the 9/11 attacks, creating a real estate bubble, he never mentioned this fact. In June, Chairman Jerome Powell expressed his determination to "tear his heart out" and firmly stated his intention to return to previous conditions. Unfortunately, the Fed currently has little it can do. The ball has passed to the executive branch. Additional policies will focus on economic stimulus through fiscal measures.