Monetary policy and reserve management in an era of uncertainty

Panellists at the Central Banking Summer Meetings with experience of ‘polycrises’ discussed reserve management strategies to prepare for and respond to financially turbulent times.

Much of the world has experienced a period of significant inflation shocks and sharply higher interest rates, following an era of close-to-zero interest rates in the aftermath of the global financial crisis that began in 2007–08. This year, inflation has abated in many countries, and monetary policy is less hawkish. However, there are still many potential geopolitical flashpoints, something that was discussed by a panel at the Central Banking Summer Meetings, which explored how monetary policy and reserve management may interact, drawing on historical examples and their significance in light of complex evolving geopolitical risks.

An economist and former governor of an Asia central bank, who held office during the financial crisis, joined an official from a central bank that is geographically close to the Russia-Ukraine conflict on the panel. The panel’s chair, an economic counsellor and market strategist from a global asset management company, said neither panellist was a stranger to shocks or the challenges that economies, their people and central banks are facing in this environment of polycrises.

The chair started by pointing out the “striking” degree of monetary policy divergence at the time among major central banks. He said the European Central Bank was the first major central bank to ease monetary policy – although central banks in emerging economies in Latin America, parts of Asia and Africa, and central and eastern Europe had already become more dovish. By contrast, the Bank of Japan only began normalising its policy in March by raising rates for the first time in 17 years – from between -0.1% and 0% to between 0% and 0.1% – ending the negative-rate interest era. The People’s Bank of China, meanwhile, has continued cutting rates, as it has done gradually since 2020.

“Essentially, you’re talking about whether or not monetary policy is making a permanent or transitory shift,” the Asia economist said. This question, in his view, can then be broken down into two further parts: “One is whether the change is of a structural nature or transitory”; the other is whether “the central bank balance sheet will go back to levels prior to the global financial crisis or [the Covid-19] pandemic”.

On the first question, which in essence “is asking whether or not a monetary policy interest rate shift is coming”, the former governor did not agree with the view of “many experts”, that the natural rate of interest, r*, has risen from its pre-pandemic levels because inflation has increased.

On the second question, the former Asia policymaker did not think central bank balance sheets would go back to pre-pandemic levels. This is because of a “curious” and “very interesting” demand for reserves. When central banks were not paying interest on reserves, holding central bank deposits came with an opportunity cost. Now, however, demand for reserves is “infinite”, he said. Despite central banks reducing the sizes of their balance sheets, some have “seen an increase in short-term interest rates”, which means “demand for reserves has increased”. In his assessment, “the increase in central bank reserves is also creating demand for reserves”. For this reason, central bank balance sheets will be “much higher” than before the pandemic.

Reserves and war

Turning to the eastern Europe official, the chair asked how her institution had managed its reserves in terms of maintaining financial stability, with shocks in both exchange and inflation rates.

“Recent years have had plenty of instability, uncertainty and the adverse effects of overlapping crises,” she said. Her country had not completely healed from events linked to the pandemic, and “was struggling with the energy crisis, when suddenly the [Russia-Ukraine] war began”. This created fear and panic because “nobody could imagine, at least in my country, that we would have a war in Europe”.

Inflationary pressures felt in the economy in the second half of 2021, and then again in 2022, were driven initially by pandemic stimulus. They were then fuelled by external prices in energy and food, and after by the effects of war. In this context, the central bank started to increase interest rates and required reserve ratios, with the aim of tempering the second-round effects of external prices to balance aggregate demand, stimulate saving, and decrease the impact on the domestic exchange rate from a widening current account deficit and capital outflows.

“I must mention that the required reserve ratio plays an important role in our monetary policy, as we face structural excess liquidity in the market, and sometimes it works even better than the policy rate,” the eastern Europe official said.

The central bank’s various monetary policy tools deployed following the start of the war were effective. “But, of course, when the war started, central banks had to adapt quickly to external shocks and to ‘black swans’ generated by this conflict.”

In the first two weeks of the military conflict, there was a lot of “uncertainty and market turmoil”, the eastern Europe official said. This caused depreciation pressures on the exchange rate as individuals and companies started to hoard foreign exchange as a precautionary measure. At that stage, the central bank intervened in the FX market in the first quarter of 2022. This amounted to $440 million – then around 12% of its foreign reserves – exhausting approximately one month of import coverage.

Other prudential measures were taken. For example, the systemic risk buffer of banks’ credit exposure to individuals was increased by 2%. “This decision sought to limit the non-cyclical systemic risk posed by increased vulnerabilities of individual borrowers in these uncertain times,” the eastern Europe official said. This measure was revoked in October 2023, as credit quality indicators gradually returned to a positive trend.

Key lessons learned during that period were that “reality may be worse than stress-test scenarios”. Central banks must “make sure an appropriate number of monetary policy instruments are in place, to be applied, if needed”. And, “the level, as well as the safety and liquidity of foreign reserves, are crucial to addressing these turbulent times”.

The eastern Europe official said that central banks should have a balanced approach to ensure sufficient liquidity to manage challenging periods, and to have some duration exposure and other instruments to increase returns on FX reserves. “Of course, the first and main objectives are to ensure safety and liquidity, but we do not have to ignore the return part,” she said. “But it’s crucial to have sufficient reserves to address such situations and to ensure you will be able to have sufficient liquidity if needed.”

Polarisation and political change

In another sign of changing times, the chair steered the discussion to a topic “that has historically been relatively far from central banks, from monetary policy and, to some extent, even from reserve management”: polarisation and political change.

In this year of elections, half of the world’s population is voting in some 64 countries. “There has been a spate of surprises and shocks,” the chair said, in the election in South Africa, the Mexican election, the European Parliament election, the snap elections in France and the UK, “with a lot of political turmoil and turbulence”.

The chair outlined two views. One is that “political shifts often seem to make a lot of difference in the headlines, but they do not really change that much in the actual underlying economic fundamentals”. In contrast, “in the US, some people think of it as a ‘make-or-break’ election”. Under a Trump presidency, a significant change in the way the international system operates may be on the horizon. The chair asked the former official at the Asia central bank how he thinks a change from President Joe Biden to Trump might affect the environment for Asia and FX reserves.

“Trump is very unpredictable,” the former Asia central bank official said. Some people are talking about trade tariffs but, for him, “what is more concerning is disruption to the global supply chain”. He added: “Asia is the heart of the global supply chain of semiconductors.” They are an essential component of electronic devices, enabling advances in communications, computing, healthcare, military systems, transportation and clean energy. If “because of heightened geopolitical risk, the global supply chain of semiconductors is disrupted, this would have a huge impact not only on Asia but also the global economy”.

Another key US election risk “is the impact on global swap lines”, the Asia economist said. Looking back at the global financial crisis, “the most important measure the central banks took was the US dollar swap line among major central banks”. But, if Trump insists on ‘America First’, in their view, a worst-case scenario is that he “will express his dislike for such a multilateral network”. For FX reserves to function as expected, the Asia economist was keen to stress that currencies of emerging market economies and developing economies need to be covered in the continuous linked settlement system (CLS), which was crucial during the global financial crisis. The exchange rate is kept constant across time zones by simultaneous settlement of a pair of currencies using a central bank account. “We’ll have to redouble the effort” at improving the CLS “and eliminating possible exchange risk”, he said.

In the face of uncertainty because of political change, geopolitical change, shocks, conflicts and crises, central banks – such as those in Russia, China, Turkey, India and Poland – have been buying gold. The Asia economist said that, for reserve managers, gold is still a good diversifier, “particularly in current turbulent global financial circumstances”. It can protect from market volatility because it is “not dependent on the swing in relative values of currencies that may affect the other central bank holdings”, and typically has an inverse correlation with the dollar. Despite the rise in cost, the former governor thinks “central banks will remain net buyers in next quarters and provide the key pillar of support for present, or even higher, gold prices”.

In terms of how the results of the US elections may play out in Europe, being near the frontline in Ukraine, and with tension between the US and Europe in mind, the Europe official observed that “for Europeans who remain highly dependent on US security guarantees, navigating this turbulent world of US domestic and foreign policy remains a matter of existential importance”. European anxiety about a potential Republican president in 2025, is particularly high, the official said. However, the official added that Europeans “expect some continuity of US foreign policy, no matter who wins the elections in 2024”.

The potential vulnerability of the EU stems from an imbalance of economic power. “Exports as a proportion of GDP are twice higher for the EU than the US,” the eastern Europe official said. However, at present, “average tariffs remain quite low” and, in the Europe official’s view, raising trade costs “will be difficult to justify”. This is because much of the EU–US trade takes place within national companies, “rather than between governments that are keeping tensions alive”.

As well as trade tensions, other issues that are of importance to the Europeans are “climate actions, the war in Ukraine and the relationships of the US with its allies”, the eastern Europe official said. Those subjects are “closely monitored” in the context of US elections, as parties have divergent policies.

On US Federal Reserve independence, the Asia economist does not think Fed monetary policy will change under Trump. Nevertheless: “The Fed is a creature of Congress,” the Asia economist said. 

The panellists were speaking in a personal capacity. The views expressed by the panel do not necessarily reflect or represent the views of their respective institutions.

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