Why are central banks looking at taking on more risk?

No one is immune to the economic realities on the ground, not even central bankers. The conundrum of how to achieve yield with an acceptable risk profile is foremost on investors’ minds. We live in a world of ultra-low interest rates and expansionary central bank policies. Combined with inflation fears on the horizon, preserving capital, let alone achieving returns, is a real issue.

Ever since the financial crisis, blue-chip stocks with a good dividend policy have taken the place of G7 government bonds, which have very low and often negative yields. Alas, these equity investments come with the associated equity risks. If investors seek return, they are increasingly driven to stocks, gold, other commodities, private equity, and other forms of alternative investments to achieve yield and hedge against inflation. This all sounds good if it were not for the heightened risk profile. Individual investors need to decide for themselves what risk return profile is acceptable to them. Certain institutional investors — like pension funds — may have regulatory limitations on what they can or cannot do. 

So far so good: How about central banks? They are the custodians of our currencies and authors of our countries’ monetary policies. They are the stewards of our economies, alongside finance ministries and other economic ministries and agencies. They dispense huge sums in asset purchases and other forms of investments. Central bankers, too, are faced with the same conundrum of how to achieve yield and protect against looming inflationary pressures. This holds especially true, because their countries’ currencies depend on their wisdom. Central bankers are traditionally risk averse. They have to live up to their role as custodians and co-anchors of our economies. Still, they too are in search of yield in order to preserve their capital. A survey by Central Banking Publications found that central banks are increasingly looking at taking on more risk. More than half of the 78 reserve managers questioned looked into investing in new asset classes and 44 percent considered taking on new currencies.

The US dollar still prevails: According to the International Monetary Fund, 59 percent of the $12.7 trillion in foreign exchange reserves are still held in the greenback. The remainder is mainly held in euros, Japanese yen and pound sterling. No wonder, then, that central bankers are considering their options while interest rates are at historically low to negative levels in these currencies.

The survey highlighted that several central bankers looked into inflation-linked bonds, Chinese bonds and gold. 

Depressed bond yields are a phenomenon that lasted for more than a decade and was exacerbated by the pandemic and the resulting expansionary monetary policies. Yields may have recovered a little, but they are still at historically low levels. Many central banks invest in shorter durations of government bonds, which in safe economies often have negative interest rates. Add inflation to that, and preserving capital becomes a major issue.

Going forward, the investment strategies of many central banks will be informed among other considerations by two interlinked factors: The outlook on inflation and interest rates. 

Last week’s April consumer price index and producer price indices in the US rang an alarm bell with the former at 4.2 percent and the latter at 6.2 percent compared to 12 months ago. A lot will depend on whether this is a transient phenomenon, or whether it persists. This in turn depends on whether inflation will extend to wage inflation, which would indicate a more permanent nature. Inflation, if persistent, will eventually feed back into rising interest rates. However, we are still a long way from that scenario.

In the meantime, central bankers need to ensure they preserve capital at minimum risk, which is a tough undertaking. The survey proved that no one escapes economic realities, not even central bankers. Economic realities may result in central bankers having to take on more risk.

• Cornelia Meyer is a Ph.D.-level economist with 30 years of experience in investment banking and industry. She is chairperson and CEO of business consultancy Meyer Resources. 

Twitter: @MeyerResources