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Podcast: the effect of monetary policy on reserve management

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This podcast explores the interaction between monetary policy and reserve management, with a focus on the Federal Reserve and the impact elsewhere. 

Escalating inflation is impacting reserve managers with high holdings of US treasuries. International Monetary Fund figures put around 60% of global reserves as being held in securities in US dollars, with foreigners holding around $7.7 trillion of US treasury debt.  
 
Quantitative tightening, the monetary policy tool currently being deployed by the Fed, means that reserve managers face their current holdings of US treasuries depleting in value. This is because injecting liquidity in the market during quantitative easing has the effect of reducing yields and increasing their value, as they are seen as a less risky asset. Now, the opposite is in play.

Yields increasing and the value of US treasuries falling has the effect of depleting foreign reserves. A key question for reserve managers, with the role of central banks changing in this high-inflation environment, is how to preserve the value of their assets. 

Central Banking is joined by Diana Dengo, investment director at Wellington Management, to talk about the effect of monetary policy on reserve management.


"We're in the middle of an investment regime change," Dengo says. "Inflation is structurally higher and more volatile, and there is, all of a sudden, a cost to central bank intervention."

Some of the drivers of the low and stable environment of the past two decades are changing. The biggest one, Dengo says, is perhaps a shift to less globalisation and more regionalisation, as well as a new set of political objectives that require more fiscal policy.

Consistently higher spending will generate more persistent inflation and generate higher-frequency cycles, Dengo says. 

In the past, central banks acted as a backstop. They could inject liquidity and the cycle would revert quickly back to growth and low inflation. Now, there is a cost to central bank intervention: the risk of ingraining even higher inflation expectations into the system. 

The effects on asset allocation will be a higher and more volatile discount rate, an expectation of more dispersion between countries and a higher value placed on liquidity. 

"From where I'm sitting as a fixed-income investor, we've experienced a once-in-a-career market correction," Dengo says. "This year, with government yields rising across the board, credit spreads widening and stocks down, there's really been no place to hide."

For countries that have currencies pegged to the US dollar, there is always a risk of importing Fed policies that may not be in alignment with their domestic economic cycle. Most central banks, however, are likely to keep following the Fed's tightening, to maintain peg stability. 

In the event of continued market volatility and financial outflows from emerging market economies driven by a global slowdown, domestic asset prices may have to adjust as the value of the currency can't change. However, in this scenario, the moderating growth outlook could help release some pressure as the Fed's tightening is also likely to slow.

"We think there will be increased differentiation between countries based not only on their fiscal trajectories but also their ability to credibly restore price stability," Dengo says. Inflation and risk premia are likely to be higher in markets where there is little or no appetite to sacrifice growth to rein in inflation. 

Index

0:20 Introduction

01:35 The changing role of central banks

04:15 What this means for asset allocation

06:05 The impact of the Fed's rate hikes on reserve management strategies, in emerging market economies, countries with strong trade links to the US and those with their currencies pegged to the dollar

09:20 How inflation expectations affect reserve management strategies

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