How Central Bankers are Fighting to keep Bond Markets Calm

Over the past several years, since the American credit crisis, central bankers around the world have been intervening in the bond markets unusually aggressively. Their goal has been to stabilize the markets and get private investors working together smoothly again. However, this goal has met with only mixed success, and in the summer of 2013, European media reported that the continent’s central bankers were again fighting to keep bond markets calm.

Even within a capitalist economy, the function of the central bank is traditionally to regulate the money supply. According to Mount Holyoke College researcher Beth Simmons, central banks like the Federal Reserve in the United States and the European Central Bank play an intricate game, trying to lower interest rates to spur rapid growth when the private economy sags, and boost interest rates when the economy is booming in order to prevent runaway inflation. However, when markets threaten to collapse altogether because of possible bank collapses or other crises, central banks have to play even more aggressive roles, trying to keep money moving smoothly enough to restore confidence. That has meant an unprecedented amount of central bank activity in the bond markets, buying government bonds as a way of effectively releasing a large amount of cash into the market.

In the summer of 2013, according to Guardian economics correspondent Phillip Inman, “another battle with the bond markets” is now shaping up. During the recession, the American Federal Reserve lowered the rates at which it loans money to the banks to virtually nothing, and central banks in other countries did likewise. The purpose, says Inman, was to encourage those banks to resume lending and investing as they had previously, in the assurance that if some investments did not pan out, they could obtain more money from the central bank very easily.

Sooner or later however, near-zero interest rates will have to be increased. When that happens, the result could be another market shock as startled investors readjust their portfolios to cope with the new higher-interest monetary economy. Central bankers know the interest rates have to be raised eventually, or they will run the risk of fuelling a new bubble of their own, one which comes with skyrocketing rates of inflation. However, they’re trying to decide how to restore normal interest rates in the long term without sparking a new market collapse in the short term.

That’s a delicate balance to have to maintain. The United States Federal Reserve Chairman appears to have crossed the line earlier in 2013 when he signalled that his institution might begin hiking rates later in the year. The markets reacted with alarm, and Bernanke changed his tune, suggesting that the inevitable interest rate increase might not be so imminent after all. In Europe, a central bank oversees the euro in many countries (but not the United Kingdom), and several countries have flirted with bankruptcy and government defaults. That makes their balancing act even more delicate: Vulnerable countries like Greece, Cyprus and Italy can scarcely afford even more uncertainty.

In the meantime, the markets remain jittery, and central bank chairs across the developed world continue to warn that interest rates will have to climb and central bank activity in the bond markets will have to slow down – eventually.