MNI INTERVIEW: Risk Fed Will Have To Buy Bonds - Bini Smaghi

The Federal Reserve runs the risk of being forced back into asset purchases, Societe Generale Chairman Lorenzo Bini Smaghi told MNI, adding that a resizing of the role of the dollar would create an opportunity to develop a European safe asset to meet global demand for an alternative reserve currency,

“There is also a third mandate in the statute of the American central bank, namely to keep long-term interest rates low,” Bini Smaghi, a former member of the ECB’s executive board, said in an interview. “This could induce the Fed to intervene again in buying government bonds, especially if the economic slowdown becomes more manifest, also because sooner or later such a slowdown would translate into a drop in inflation anyway.” (See MNI INTERVIEW: Independent Fed Key To Inflation Fight-Raskin)

Recent market events have been only a first sign of a possible structural change and a signal that foreign investors in particular are watching the sustainability of U.S. debt with great attention, though for the moment it remains impossible to predict whether the world faces a shock which would call into question the centrality of the dollar, he said. Such an event would lead to a fragmentation of financial markets and the depreciation of many assets, said Bini Smaghi. (See: MNI INTERVIEW: U.S. Safe-Haven Status Under Pressure - Liang) 

“The Trump administration has done well to take this signal seriously, but there are still too many uncertainties about the direction economic policies will take in the coming months,” he said, noting that if tariffs remain in place there is an increased risk “of an snowball effect on government debt and a more serious loss of confidence, which could create severe instability in international financial markets."

BOND VIGILANTES

“In other words, bond vigilantes have awakened. This is not necessarily a bad thing, depending on the measures that the Trump administration will take from now on,” he said.

An erosion of the U.S. currency's reserve status could be an opportunity for eurozone nations to issue more joint debt, otherwise the ECB will have to absorb the impact of a falling dollar through liquidity creation and avoid excessive euro appreciation, Bini Smaghi said.

“We would need a political agreement between the euro countries to create a European safe asset, such as the one produced to finance the [pandemic] national resolution plans,” he said.

“I see the risk of an abrupt withdrawal of the U.S. banking system from the European economy, in the event of a liquidity drain on the dollar. In this case, European banks would have to increase their lending to compensate for this effect,” he said, noting that it remains to be seen whether they are able to do this.

Still, European banks are in a solid position , “at least until that risk becomes systemic, in which case economic policy intervention would be necessary anyway,” he said.

“A key issue is the maintenance of liquidity lines, in the form of swaps, between central banks, which were instrumental in stabilising the markets during the great financial crisis of the past decade,” he added.