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The New Era In Central Banking: Credit Policy

Published by Anonymous (not verified) on Thu, 03/12/2020 - 1:00am in


central banks

With interest rates hitting their effective lower bound, and the general skepticism towards the effects of growing central bank balance sheets via buying central government bonds, central bankers are being forced into a role they had largely avoided: directly extending credit to actors other than the central government. In some ways, this is a reversion to pre-World War II norms. From an analytical perspective, this shift largely eliminates the usefulness of most macro theory with respect to monetary policy.
Balance Sheets Have to BalanceThe first point to address: why do central banks need to lend money in the first place? The answer is straightforward: balance sheets need to balance.
Currency in circulation (e.g. dollar bills) are liabilities of the central bank. The central bank does not give those notes away for free; they need to receive something in return. 
If the currency were pegged to another instrument (gold, another currency) and backed 100% by the other instrument, then the answer is straightforward: they need to get the backing instrument in exchange for the notes.
For a fiat currency issuer, there is no backing instrument. So the central bank needs to get something from the private banks that want notes. That something is usually bonds, or the central bank can make loans to the banks against collateral (discounting, or rediscounting).Double Layer of Credit ProtectionCentral banks are banks to banks. Although they are currently a giant employment programme for Ph.D. economists, they do have large staffs that can do credit analysis, monitor loans, and work out defaults. As such, the normal preference is to lend against collateral presented by banks. This gives them two layers of protection: the loan is actually to the bank, and if the bank fails, only then do they worry about the underlying loan. Since they are supposed to be regulating banks, central banks should be able to lend to them with some confidence that they understand the business.
Admittedly, central banks were forced to dabble in private securities in the aftermath of the Financial Crisis. However, they quite often had asset managers managed the portfolios, or else they were hoping that diversification will bail them out (like many credit investors).
One of the side effects of the central bank lending against a class of securities is that this effectively turns those securities into money-like instruments: an important class of money market participants can always get government money at a known haircut with those instruments. The implication is that the collateral decisions can influence money market behaviour.The Post-War FrameworkCentral banks loaded up their balance sheets with central government debt in World War II, and the changes in the economics profession kept it that way in peacetime. As Minsky noted, by having the central bank lend against government debt, the central bank was no longer tied to lending to the private sector. It just majestically determined the money/bond allocation for private portfolios, and was freed to be a benevolent central planner that set the money supply to achieve optimal outcomes.
The end result of this shift was that central banks were staffed with Ph.D.'s who spun out fancy mathematical models, and who had no idea what the financial sector was up to in 2008. Those models turned out to be useless, and so policymakers were forced to dig up copies of Lombard Street and bring in private firms to manage portfolios of toxic securities. 
Although I imagine it might not be universal, central bankers are now aware of these issues. (Outside central banks, learning might be slower. Remarkably, I had a recent online discussion with an anonymous mainstream economist who insisted that the Fed set LIBOR, and that the LIBOR-Fed Funds spread was zero.) Although I am far removed from the financial information pipelines, I think there is no doubt that central banks provided a far more competent response to 2020 than 2008.Blowing Up Monetary Policy ModelsHaving central banks operating in the credit markets blows up models, particularly neoclassical models. DSGE models are arbitrage-free pricing models, which are never going to realistically deal with defaults.
Anyone wanted to apply quantitative thinking to these interventions are going to have a hard time. The reality is that the only useful quantitative metric will be prices (or more accurately, spreads). However, credit spreads will be the result of interventions, and there will be no useful link to size of interventions -- which quantity theory obsessed economists will focus on.
The other issue is that central bankers seem to be highly sensitive to free market enthusiasts screaming about "central banks destroying price discovery." If they followed a sensible operating procedure -- announce target spreads that they will operate at, it is clear to everyone that they are engaging in a price-fixing operation. Since that will offend their neoliberal sensibilities, they will put the focus on the size of the operations -- which may tell us nothing about price.Supply and Demand StoriesOne of the common features of economists is that they love supply and demand stories when it comes to fixed income markets. This includes some post-Keynesian economists, who otherwise sneer at supply and demand diagrams.
There is no doubt that if a large investor makes large orders, prices can immediately move. The question is: by what amount, and how persistent will they be? In practice, persistence is a lot smaller than economists' stories suggest.
Let us look at a market in a particular risky instrument. If we look at the current owners and potential buyers, we could theoretically infer supply and demand curves based on the spread.
The working assumption that economists like is that there is a wide distribution of views about the instrument, and so the supply and demand curves would imply smooth movements of the spread if a large actor (like the central bank) wades into the market.
However, if the bulk of trading activity is done by a relatively small number of entities with similar valuation metrics for the security, then the effect can be tiny. The portfolio managers just reallocate to fungible instruments, and since "everyone" has similar valuations, any price changes would be fleeting once the squeeze on dealers' inventories has passed.
If we are discussing the level of rates, we can see why supply/demand effects were generally weak in response to QE (with the exception discussed later). Unlike economists, fixed income investors generally take mathematical finance seriously, and understand how rate expectations work. The dispersion of views about near-run rate trajectories were not wide enough that central bank purchases were enough to move them. Duration is fungible, and so central bankers taking some out of the market did not change things that much.
(The exception is in ultra-long maturities, where the private sector cannot credibly supply duration, and there are captive buyers courtesy of liability matching. Central bankers can squeeze 30-years, and even 10-years where private bond issuance is not as vibrant as the USD market.)
If we turn to credit, the fair value of spreads is the sum of default risk and liquidity premia. In aggregate, credit is fungible (since a lot of investors just buy the index and pray for diversification), and so it would take extremely massive interventions to move the median spread. However, it is possible to move the spread on individual credits, since there might be a wider dispersion of views regarding default risk.Either Go Big, or TargetEither central banks need to launch massive interventions to reduce aggregate spreads, or they do targeted interventions. Massive interventions would be highly dangerous politically, so I would expect more in the way of targeted interventions -- which have already taken place.
Unfortunately, we have no way of calibrating the interventions. For the credits being bought are widely perceived as safe, then the purchases will just force a minor rebalancing of portfolios, and the purchases would have no real effect. It is only the purchases that save borrowers that really matter. Since we will have no way of knowing which is which, any aggregate credit purchase amounts will be mixing the two categories of lending. This means that a hypothetical intervention that is twice the dollar the amount of another could actually have less of an effect if it is targeted in the wrong sectors.Sub-Sovereign Lending the Path of Least ResistanceThe central bank bailouts of bankers in 2008 led to political blowback across the political spectrum. Central bankers bailing out well-connected individuals could easily lead to another swell of populist discontent -- even if the actual deals are done in above-board fashion.
The cleanest solution to central bank lending is to lend to sub-sovereigns (or sovereigns, in the case of the ECB). We already saw provincial bank repo operations in Canada in 2020, and state and local lending facilities are a major concern in the United States. Such lending has the advantage of being targeted, yet not being seen as being tied to individuals like CEOs.
The other alternative is to buy riskier assets on a portfolio basis (e.g., ETF's). At best, this just fuels asset price bubbles. However, the link from financial asset bubbles and the real economy is tenuous; we have had sub-par real growth since the 1990s, despite a series of bubbles. In any event, given the fungibility of risk assets, the analysis is going to be nothing more than glorified dual y-axis charting -- which works until it doesn't.A Semi-Automatic StabiliserNo matter how large the central bank credit interventions get, they are likely to be defensive in character. They will keep particular entities solvent, allowing them to keep their current pattern of spending intact.
This will prevent drops to activity. But it is much less clear whether this will lead to any acceleration in activity. The post-1990s trend has been one of sluggish growth, with the main stimulant being housing market bubbles. There is no reason to believe that these central bank activities will change that tendency.Analysis is Going to be QualitativeRegardless of the path chosen, the only sensible line of analysis will be largely qualitative. What sectors is the central bank lending to? What will be the effect of the lending? Changes to the size of the central bank balance sheet are not going to add any useful information, other than providing fodder for fans of dual y-axis charts.
(c) Brian Romanchuk 2020

Central Banks Are Always Involved With Government Finance

Published by Anonymous (not verified) on Sun, 18/10/2020 - 1:17am in


central banks, MMT

I have been seeing quite a few comments to the effect that central banks are propping up government bond markets now, and what happens if that stops? This is akin to saying the Bears 46 defence was not that good if they did not have all those players who were tackling their unlucky opponents. That is, that is how the system works, and it is a basic misunderstanding to expect things to be different.
I will mainly concentrate on Canada, where Quantitative Easing (QE) is a novelty.  There have been some parallel discussions in the United States, where I will make a few comments (where I do not have strong convictions, so they will be short). 
The easiest way to understand government finance in Canada is to buy my book, which coincidentally has the title Understanding Government Finance (link). In it, I do MMT-style operations analysis on a simplified version of the pre-2020 Canadian system (in Chapter 3). The operations look very different than the pre-2008 U.S. system based on required reserves, which is the basis of most textbook descriptions.
 Bank of Canada balance sheetThe above figure shows the balance sheet structure of the Bank of Canada (BoC) during normal conditions. (Time scale is 2012-2019 to avoid the deviations caused by crises.) The top panel shows that the liabilities of the BoC are mainly two items: bank notes in circulation (dollar bills, coins), and a deposit by the Federal Government (the Receiver General account). All payments to and from the Federal Government end up at this account; the Federal Government does not bank at private banks (at least with respect to Canadian dollars).
The bottom panel is what makes the Canadian system normally different than the U.S.: it shows the deposits at the BoC by the members of Payments Canada (the wholesale payments system), which are private banks. These correspond to "reserves" in American parlance, but is a misnomer since reserve requirement have not existed in Canada since the 1990s. (The Fed finally dropped reserve requirements to 0%, so we might see convergence in terminology.) As the figure shows, banks have a target balance for their overnight balance at the BoC/payments system of $0, and this is for all intents and purposes achieved. (Note that the balances were non-zero during the Financial Crisis, and now as a result of QE).
Let's assume that the banks perfectly hit their $0 target every day (which is close to reality). What does that mean? It means that the BoC has to offset perfectly the net transactions in the Receiver General account. 
So what? Look at what happens on a hypothetical day where the Federal Government issues a bond, and everything else nets to zero. The BoC has to inject exactly the same amount of money into the private banking system. Under normal circumstances, this is either:

  • the BoC buys other Government of Canada bonds (the BoC normally takes down a portion of bill auctions, which would cause some neoliberals' heads to explode), or
  • the BoC "lends" against Government of Canada bonds via repurchase agreements.

In other words, 100% of the auction is "financed" by the BoC operations. All the auction does is increase the Receiver General account balance, the BoC balance sheet grows, and private sector balance sheets are rearranged (they end up with new bonds, and either have repo liabilities or sell bonds to allow this).
If 100% of GCAN auctions are normally "financed" by the BoC, it makes no sense to ask the BoC to step away from financing the Federal government.
Let us pretend some brain surgeon wants to "wean the Federal Government off this dependency." What would they do? They need to ramp up the Receiver General account size to give a larger buffer to eliminate the risks associated with rollover risk. All this does is bulk up the BoC's balance sheet: the Federal Government increases its gross issuance, but other bonds (or repos) just pile up on the asset side of the balance sheet. From the private sector's perspective, this is just generous corporate welfare to primary dealers (mainly banks): they buy some bonds at auction, then flip other ones right back to the BoC. The spread they earn on flipping increases, while the net debt outstanding has not changed.
Although this policy might be popular with banks, I think we need to be stern and wean them off welfare. There are plenty of grocery stores that need delivery people if they need the extra cash.
If we look at 2020, there are two factors that are amplifying the amount of purchases by the BoC.

  1. The Federal Government has increased its balance, which implies the flipping mechanic described earlier.
  2. The BoC decided to be like the other cool New Keynesian kids, and plunged into QE operations. Aggregate private bank balances are no longer zero, they are being forced to be positive. This means that the BoC has to buy or lend against bonds.

However, not all operations are GCANs, the BoC has waded into provincial names as well. My guess is that this was probably needed to allow the issuance needed to survive the crisis, since funds may have hit risk limits (and might be wary of default risk in the middle of the panic). Canadian provinces are the front end of the Canadian welfare state, and so their finances are more pro-cyclical than U.S. states.Post-Script: U.S. Treasury Market Too Darned Big?There was some excited chatter about remarks by the Fed's Randal Quarles. They suggested that the Treasury market had grown too big for private markets to support, and so the Fed would need to keep intervening.
I am unsure about the context of those remarks, and I believe that they are tied to some technical work that has not yet been fully unveiled. As such, I do not have much conviction about what he said.
However, my feeling is that people are not looking at this like the Fed does. The New Keynesian Federal Reserve is obsessed about monetary policy settings being transmitted without distortions (which is probably why they publish term structure models that ascribe all the volatility in market prices to moving term premia, and not rate expectations or inflation breakevens). There is an extreme distaste for Treasury market volatility.
Fixed income markets are dealer markets, and their capacity to warehouse risk is always finite. There is always the possibility that there could be short-term flows that overwhelm that capacity. However, the Treasury Market is a market, and there is a mechanism to deal with such imbalances: price changes. Just let prices crater enough, the markets will clear at some point. Meanwhile, such price volatility generates profit opportunities for competent dealers, and so they might increase trading capacity.
This is a dilemma created by ascribing to neoliberal mythology. They want to insist that Treasury market pricing is a free market, so that there is a cudgel to threaten fiscal policy with. But at the same time, they do not want their precious monetary policy interrupted by markets acting like markets. A basic rule of thumb is that if you ask for the impossible, do not expect to get it.
(c) Brian Romanchuk 2020

Inflation Targeting: Keep It Simple

Published by Anonymous (not verified) on Thu, 17/09/2020 - 10:37am in


central banks

The Powell press conference came and went, discussing the Fed's new approach to inflation targeting. My view is that not much has changed, and we just face largely pointless debates about messaging -- which are predicated upon the questionable assumption that expectation management can fine-tune economic growth.
(For this article, I will assume the conventional view that interest rate policy can be used to control inflation. I have severe concerns about this, but if we do not assume that the central bank can fine tune growth to match arbitrary trajectories, the story is a bit more plausible.)
My view is that the basic inflation target framework followed by some countries is the most practical version. If we assume a 2% central target, just say that the central bank definitely wants to keep inflation between 1% and 3%, and be vague after that. (Yes, the central banks typically have more strict targets, but since nothing happens when they miss, that is no big deal. If the target was supposed to 2%, just forecast that inflation will be 2% at the end of your forecast horizon.)
The alleged problem with the 2% target is that if the 2% level is treated as a ceiling during the expansion, then the average over the cycle will tend to be below 2% -- since inflation drops in a recession, and recovers slowly. 
The Fed dealt with this problem by adding a vague averaging clause. However, this was only an issue in the last cycle -- inflation bounced above target during the expansion in various countries in earlier cycles with inflation targeting. (Pre-2008, central bankers in a few countries were crowing at what a great job they did hitting their target on average.) 
The only practical difference of this change is that this gives the Fed more room to wait on rate hikes. However, that really is only going to be true if the inflation experience repeats. It is not a law of nature that inflation must stick below 2% for a decade. Meanwhile, if inflation is in fact stable at a low level as in the last cycle, then the rise in rates would be mild, and probably would have no measurable effect on the economy.
Although the policy has been described as an average inflation target, it was unclear to me how symmetric the averaging is. (An earlier document only discussed deviations below a 2% average.) If inflation has averaged 2.5% for an extended period, will the central bank attempt to drive it down to 1.5% to balance this out? Neoclassical models suggest that the central bank can make the inflation rate follow a complex trajectory. I have doubts that the inflation rate can be fine-tuned that easily amid an expansion -- disinflations tend to be driven by recessions. Is the central bank going to risk inducing a recession if the inflation rate is stable at 2% in order to meet the average inflation mandate? If not, then we have to accept this is not really average inflation targeting, this is just a tweak to try to avoid the problems of the last cycle.Simpler AlternativeA simpler alternative to averaging is to just to tell the central bank to be happy with any inflation rate between 2% and 2.5%. If you want an objective function, it has a dead zone. This means that the central bank will sort-of target 2.25%, but will not care if it drifts from that precise target. I would not view this as being much of a change, as this sort-of described the inflation trajectory in the pre-2008 cycles. (After all, some of the central banks hit their inflation targets on average.)
Allowing for 2.5% instead of 2% inflation might scare some people, but they are being unrealistic. Adding 0.5% to the average realised inflation rate only would make a difference on a long horizon -- a decade or more. The shift of the consumption basket means that price level comparisons over such horizons are sketchy anyway. There is no sign that any entity is sensitive enough to the CPI to care about such a small difference. Firms are worried about their input costs (including labour), and their specific outputs. People fret about inflation, the existence of websites that make money telling people that "inflation is really 8%" tells us that they have no idea what the actual rise in prices is. 
(c) Brian Romanchuk 2020

Fed Rearranges Deck Chairs On Monetary Policy Titanic

Published by Anonymous (not verified) on Fri, 28/08/2020 - 5:25am in


central banks

The Federal Reserve has announced some changes to its description of the long-term objective of policy (link). From an operational perspective, this change is entirely cosmetic, and accomplishes nothing useful. It is really a distraction from the reality that the Fed is pushing on a string. The only way forward for monetary policy is for it to be transformed into fiscal policy.

The meat of the change is as follows:

In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

This is  policy commitment that has all the robustness of a paper bag that has been left out in the rain for a few weeks. Since there are no numerical dimensions to the statement, a single print of 2.1% inflation is enough to satisfy the criteria before the Fed launches a rampage of rate hikes.

This change only makes sense as a political maneuver to deal with neoclassical economists who are obsessed with monetary policy. A tiny change was made to allow the Fed to claim it "did something," while ignoring the questionable calls for level targets.

(Note: For an alternative take on this issue, I recommend Skanda Amarnath's article on doubling down on inflation targeting. The article discusses an issue that I did not cover here -- the tendency for the Fed and fixed income markets to continuously over-react to rising inflation. Of course, other markets are worse -- gold market commentators have correctly predicted the last 20 of the past zero hyperinflations in the United States. )
If the Fed Can't Hit 2% Inflation, It Isn't Going to Hit 2.5% EitherAlthough a certain amount of grudging respect has built up for the Zero Lower Bound (or more accurately, The Effective Lower Bound), neoclassical economists are still all-in on the belief that monetary policy can be used to micro-manage the trajectory of the economy.

One needs to view the conventional consensus on interest rates with skepticism. Observed economic outcomes can be explained by the possibility that interest rate policy is a very weak tool, and its effectiveness lies in rapid rate hikes engineering a crisis and recession. Stimulating faster growth is not easily done -- the "pushing on a string" problem.

Mainstream academics and central bankers are spending a good deal of time arguing about the optimal design of monetary policy, while ignoring the "pushing on a string" elephant in the room.
Level Targeting -- Oh DearThe idea of nominal GDP level targeting (NGDPLT) is popular in some circles. Instead of announcing a target rate of growth, a specific level of nominal GDP is targeted, with the target growing at a fixed rate (typical suggestion of 5%).  In an ideal world where deviations from target are small -- and monetary policy can fine-tune the economy -- it sounds reasonable.

Unfortunately, we no longer live in that world. If there is a massive downward deviation in nominal GDP, policymakers are stuck with three choices.

  1. Try to have nominal GDP grow slightly above target (5.5%) for a decade. This is largely indistinguishable from just saying the central bank wants nominal GDP growth to be "around 5%."
  2. Engineer (somehow) a massive overshoot of 5% nominal GDP growth, so that the target level is hit. The question then arises -- how does the economy transition back to 5% growth from something like 9%? In that environment, why would inflation expectations be anchored? (This ignores the entire "pushing on a string" concern.)
  3. Or just go "whoops" and revise the target to be closer to current level of nominal GDP, and have the target grow at 5%  year from there. This ends up being identical to a framework that wants "nominal GD growth to be round 5%."

Things are obviously worse if we somehow got a major inflationary overshoot of the target. Are policymakers going to engineer a depression out of fealty to some target level, or just revise the level? 
(The interesting thing about neoclassical economists is the compartmentalisation of thinking. Time consistency is only applied to show that fiscal policy has an inflationary bias. This is viewed as an extremely important result. Meanwhile, no attempt is made to ask whether new proposals for monetary policy are time consistent.)Turn Monetary Policy into Fiscal PolicyTo get around the "pushing on a string" problem, various proposals to turn what are obviously fiscal policy tools over to the central bank. Since Ricardian Equivalence is generally not taken seriously, there are few doubts that fiscal policy can (eventually) stimulate faster nominal growth (e.g., real growth, or inflation otherwise).

Neoclassical economists are still stuck in the 1960s optimal control mindset, and believe that technocrats can micro-manage the cycle. To be fair, almost anybody could do a better job than the current legislative branch of the United States government. However, this fecklessness reflected the consensus that fiscal policy was ineffective, and only monetary policy was needed to guide the cycle. The neoliberal consensus got exactly what they asked for, and the result was a failure (as they were told at the time).

However, this political quick fix could easily fail. Hard money ideologues would howl if the unelected central bank started spending money. Furthermore, there is no free lunch. No matter whether one is a MMTer or conventional economist, there are constraints on fiscal policy. The central bank engaging in fiscal policy is infringing on the policy space of the legislature. It would be completely unsurprising if fiscal conservatives announced cuts to social programmes to counter-act fiscal actions taken by the central bank. Given that considerable effort is made by legislatures to target spending, having those programmes dismantled to compensate for the central bank firing money out of a firehouse would most likely result in worse outcomes for society.

(c) Brian Romanchuk 2020

Who Sets The Yield Curve?

Published by Anonymous (not verified) on Mon, 10/08/2020 - 10:42am in

There was a debate on my Twitter timeline whether or not the Fed sets the entire yield curve. Since I am in the midst of writing a MMT primer, the party line is bubbling up in my mind: the yield curve is a policy variable. However, the exact mechanism is not entirely obvious, and the situation is arguably ambiguous.

The following Joe Weisenthal tweet started the discussion:

This got a response from David Beckworth:

I am closer to Weisenthal's view than Beckworth's, although I have reservations about the wording (as I will discuss). I do not want to go through a detailed response to Beckworth's comments here.
What We Can Say for SureOne of the problems generated by Economics 101 textbooks is that readers have a tendency to refer to "the" interest rate. There is a multitude of fixed income instruments, and each has its own rate of interest/yield. At the minimum, we need to refer to a "risk-free curve." But even that is a simplification - there are a number of cash instruments that qualify as "risk-free" in the United States.

  • Rate of interest on settlement balances at the Fed ("reserves").
  • Rate of interest on inter-bank settlement balance lending ("Fed Funds").
  • Repo rates on Treasury collateral.
  • Yields/rates on Treasury bonds/bills.

(There are also derivatives based on these instruments that should be priced in a coherent fashion as well.)
Only the first instrument listed -- rate of interest on settlement balances -- is explicitly set by the Fed. The others are influenced by open market operations, with the objective of keeping the Fed Funds rate in its band. (The targeting procedure has changed over time.)
Specialists whine whenever spreads appear between these various interest rates at short maturities, and write breathless editorials about the Fed "losing control of interest rates!" However, anyone who understands the concept of duration realises that the returns implications are exceedingly uninteresting to anyone who is not a money market trader.
However, the sloppiness of Fed operations means that when we write "the Fed sets the short-term risk-free rate" implies that it might need to undertake various gymnastics to keep these various risk-free curve in line with each other. Nevertheless, the basic principle remains that short-term rates will stick near the Fed target, barring the U.S. Congress threatening to default (e.g., debt ceiling woes).
The question remains: what about longer-term yields?Fed Officials versus The Fed Reaction FunctionThe issue with Joe Weisenthal's tweet is that he wrote that the yield curve is set by "the Fed," when in fact it is the Fed's reaction function, as measured by market rate expectations.
Given that the initial maturities on the risk-free curve are set by Fed officials, forwards reflect the market pricing for future settings. This market pricing may not align with what Fed officials think they will do in the future, which was the alleged "Conundrum" of Al Greenspan. Bond Conundrum, My ....
The figure above demonstrates why the worry that bond yields were "too low" in 2005 makes no sense: realised rates over the subsequent decade were much lower than those "low" yields. The market is supposed to be a forecasting mechanism, are we to be shocked that its forecast was at least roughly correct, while a bunch of central planners who were completely blind-sided by the Financial Crisis were wrong?
Government officials shy away from predicting recessions (or that they have completely failed in their duty to regulate the financial system). As such, there is no reason to believe their forecasts of the future. The only thing that can be trusted is where they are setting the short-term rate now; where the short-term rate will be in the future depends upon future economic conditions -- which may be nowhere near where policymakers are publicly predicting.
As such, what matters is the reaction function of policymakers, not their forecasts. If we assume the term premium is zero, we can read out the market implied reaction function by reading off forward rates. (The term premium is obviously not zero, but it is not that large or variable, either.)Yield Curve ControlThe Twitter discussion bled into "yield curve control" -- the central bank setting the entire curve directly by putting price limits on Treasury securities, and intervening to defend those price limits. Doing so is certainly possible, but doing so would obliterate any information in the yield curve. Bond pricing would shift to guessing where the target range would move, coupled with carry analysis to see whether the target curve shape is coherent with projected short rates.
In such a case, Fed officials are arguably setting the entire yield curve, and there is no distinction between them and the reaction function.

(c) Brian Romanchuk 2020

Britain was not "nearly bust" in March

Published by Anonymous (not verified) on Wed, 24/06/2020 - 2:49am in

"Britain nearly went bust in March, says Bank of England", reads a headline in the Guardian. In similar vein, the Telegraph's Business section reports "UK finances were close to collapse, says Governor":Eh, what? The Governor of the Bank of England says the UK nearly turned into Venezuela? Well, that's what the Telegraph seems to think: 

The Bank of England was forced to save the Government from potential financial collapse as markets seized up at the height of the coronavirus crisis, Governor Andrew Bailey has said. In his most explicit comments yet on the country's precarious position in mid-March, Mr Bailey said 'serious disorder' broke out after panicking investors sold UK government bonds in a desperate hunt for cash. It left Britain at risk of failing to auction off the gilts needed to fund crucial spending - and Threadneedle Street had to pump £200bn into markets to restore a semblance of order.

Reading this, you would think that the UK government's emergency gilt issues had triggered a sterling market meltdown, wouldn't you? If this is indeed what happened, then the Bank of England has strayed far beyond its mandate and compromised its independence. Why on earth the Governor would voluntarily admit this surely requires some explanation. After all, if it is true, it could cost him his job. The source for the Telegraph's extraordinary claim is this 51-minute podcast from Sky News, in which Sky's economics editor Ed Conway and former Chancellor Sajid Javid grill the Governor on his handling of monetary policy during the coronavirus crisis. The particular part of the interview that has raised eyebrows is in this clip, which I have transcribed here:

Bailey: We basically had a pretty near meltdown of some of the core financial markets….I got to Wednesday afternoon, and the markets team came down here, and you know it’s not good when they turn up en masse, and you know it’s not good when they say “we’ve got to talk”, and it wasn’t good. We were in a state of borderline disorderly, I mean it was disorderly in the sense that when you looked at the volatility in what was core markets, I mean core exchange rates, core government bond markets, we were seeing things that were pretty unprecedented certainly in recent times, and we were facing serious disorder.

Conway: How scary was that? What would have happened if the Bank hadn’t stepped in?

Bailey: “Oh I think the prospects would have been very bad. We would have had a situation in which in the worst element the Government would have struggled to fund itself in the short run”. 

So no, the market meltdown was not triggered by high government spending. The market meltdown was because of investors panicking about Covid. It did, however, threaten to cause a government debt crisis.

Or - did it? Government struggling to fund itself "in the short run" simply means that it might have needed to pay out money before it could raise it. Normally it would cover short-term cash needs by issuing Treasury bills, which are short-dated, highly liquid bonds with very low interest rates. But when markets are malfunctioning, it can't do this. And high-interest gilts or pandemic bonds would take time to issue. So it could potentially find itself short of ready cash for urgent spending. However, as I have explained before, not being able to raise immediate funds for an urgent purchase is not insolvency, it is illiquidity. Relieving temporary illiquidity is what central banks do, and have done since the time of Bagehot. Historically they have done so not only for banks, but also for governments. And in the UK, the Bank of England still bears this responsibliity. The Ways and Means overdraft (which was extended in April) is the living evidence of the Bank of England's role as liquidity provider of last resort for the UK Government. But it is simply a working capital overdraft, such as any solvent business would have. Using this overdraft in no way implies that the Government is "insolvent", "bust", "bankrupt" or any of the other inflammatory headlines that journalists like to use. And nor does it mean the Bank of England is financing government deficit spending on anything other than a very short-term basis. It simply smooths out cash flow. Conway's assertion that the Government was "within a whisker of insolvency" is total nonsense, as is the Guardian's claim that "Britain nearly went bust in March". The Government was not shut out of markets long-term, as an insolvent sovereign would be. It had short-term cash flow problems solely because markets were malfunctioning.  Indeed, in another part of the interview Bailey said exactly this (my emphasis):

Conway: At the time you were nervous about government not being able to finance itself. 

Bailey: Yes, because of market instability.

Bailey went on to explain that the reason why the Bank intervened was not because the Government was having funding difficulties, but because market instability was driving up interest rates across the entire economy, and indeed across the whole world:

How would this have played out if we hadn’t taken the action that we and other central banks took? I think you would have seen a risk premium enter into interest rates, I think markets would have priced in a risk premium, and it could have been quite substantial given the degree of instability we were seeing. That would have raised the effective borrowing cost throughout the economy. In terms of the Bank of England's objectives, that would have made it harder for us to achieve our objectives, both in terms of inflation and in terms of economic stability.

The market meltdown was weakening central banks' hold on interest rates. They had to act, not to protect government finances but to prevent monetary conditions from tightening sharply, potentially triggering a dangerous debt deflationary spiral. The first responsibility of central banks in this crisis has been to prevent an exogenous shock to the real economy from triggering a financial crisis that would amplify the shock and significantly deepen the inevitable recession. That's what the exceptional interventions by central banks, including the Bank of England, since March have been all about. 
Bailey observed that although the UK Government was the largest borrower in the sterling market, it was far from the only one. Big corporations were borrowing enormous amounts, both in the market and from banks. Interest rates were rising on their bonds as well as government bonds. So the fact that the Government was the largest borrower was "actually largely irrelevant to that argument about a risk premium and an increase in the effective rate of interest."Bailey said that the £200bn of QE announced by the Bank of England the day after his crisis meeting with the markets team was to provide emergency liquidity to the whole market.  By injecting very large amounts of liquidity into the market, the Bank of England aimed to slake investors' thirst for cash and stop the fire sales that were driving up interest rates. And it succeeded. As a by-product of this action, the UK Government regained access to short-term market funding. But Bailey insists that ensuring the Government could fund itself was not the primary target. Regaining control of interest rates was. 
The market meltdown in March also affected banks. It's a measure of how far we have come since 2008 that Conway & Co made nothing of the fact that the Bank of England had to provide emergency liquidity support to banks. Keeping banks afloat when markets are melting down is all in a day's work for a central bank, these days. Nothing to look at at all. But if a central bank provides emergency liquidity support to a government struggling to raise short-term cash when markets are melting down, that means the government is bust, the central bank is captive and the country is Venezuela? How utterly absurd. 
I found the interviewers' constant focus on government financing a serious distraction from what was an important story about the Bank's vital responsibility for ensuring the smooth operation of financial markets. When financial markets melt down as they did in 2008, the whole world suffers. Central banks saw the same thing happening again in March 2020, and acted to stop it. And their action was extremely effective. It seemed to me that this was the story Bailey really wanted to tell, but the interviewers were intent on pushing him towards the issue of monetary financing and the Bank's independence. Sajid Javid, in particular, seemed to want Bailey to paint the Chancellor's handling of the crisis as irresponsible and profligate. Which genius at Sky News thought it was a good idea for the Chancellor who was forced out of his job without ever producing a Budget to discuss the performance of his successor with the Governor of the Bank of England?
Finally, it is extremely unfortunate that none of the media reports highlighted Bailey's strong endorsement of the Government's exceptional measures to support people through this crisis:

It's entirely necessary that the state has to step in at this point. In a shock of this nature, you can't leave it to individual citizens to find their way through it, "well, good luck" sort of thing. The state has to assert its role at this point, which it did. It wasn't easy, but it did it. 

Fiscal policy is pre-eminent. The Bank of England's job is to ensure the smooth functioning of markets and keep the economy as stable as possible so that the Government can support people through this crisis. And that is what it is doing - successfully. This, not "Britain nearly went bust", is what should be on the front page of every newspaper. 
Related reading:
Pandemic economics and the role of central banksThe End of Britain?

Pandemic economics: the role of central banks and monetary policy

Published by Anonymous (not verified) on Tue, 16/06/2020 - 3:21am in

Below are the slides from my presentation at Beyond Covid on 12th June. The whole webinar can ve viewed here.
The pandemic seems to me to resemble the "nuclear disaster" scenarios of my youth: hide in the bunker, then creep out when the immediate danger is over, only to find a world that is still dangerous and has fundamentally changed in unforeseeable ways. 
Rabbits hiding from a hawk is perhaps a kinder image, though hawks don't usually leave devastation in their wake. And I like rabbits. So this presentation is illustrated with rabbits, not nuclear bombs. 

This is where we were in March/April/May. Hiding in our homes, waiting for the danger to pass:

And this is what central banks should have been doing then:

To their credit, this is exactly what they did. By supporting sovereign finances and warding off a financial crisis, they enabled fiscal authorities to take the extraordinary measures needed to keep people and businesses alive in their burrows. 

Some economists mistakenly called for central banks to do demand stimulus such as helicopter money. But it was completely the wrong time for this. Why dangle carrots in front of the burrows to entice the bunnies out while the hawk is still flying overhead? Fortunately, central banks ignored them. 
This is where we are now:

Even if all restrictions were lifted tomorrow, demand recovery would be slow because people have suffered a severe knock to their confidence. Indeed, suddenly lifting all restrictions could send the bunnies scurrying back into their burrows. The world has become a dangerous place. 
So what should central banks be doing right now? More of the same, really:

While restrictions remain in place and confidence is severely dented, it is too early for major stimulus of household demand. However, central banks could at this point do limited stimulus aimed at businesses rather than households, such as conventional QE and encouraging bank lending to SMEs.
What does the future look like? Well, it won't be the same as before:

The economy will need a lot of support for a long period of time. How can central banks help to provide this support?

The implication of all this is that central banks need to rethink their mandates and their relationship with fiscal authorities:

The era of dominant central banks is over. Central banks' primary role is to support governments so that they can do "whatever it takes" to maintain jobs, incomes and prosperity. 
The responsibility of the major central banks, especially the Fed, extends to the governments of developing nations. FX crises in developing countries have a habit of coming back to bite advanced nations. And the humanitarian cost of failing to support countries with high FX debt through these exceptional times is far too high to bear. 
Related reading:
When is the right time for UBI and helicopter money?We must avoid repeating the same mistakes in our economic response to the coronavirus - The New European

Doing "Whatever It Takes"

Published by Anonymous (not verified) on Mon, 27/04/2020 - 10:52pm in


central banks

The economy slumbers in its induced coma. Businesses are closed, workers furloughed or laid off. But the astonishing headline falls in economic indicaters such as GDP and PMI conceal a grim reality. Businesses are closing not just because they have been ordered to do so, but because they are running out of money. And people who have lost their jobs or become ill are also running out of money. If businesses fail instead of being mothballed, the eventual economic recovery will be slow. And if people die of starvation or untreated disease, what is the point of the lockdown?

Everyone agrees that there is an urgent need to get money to people and businesses so they can stay alive. But the waters are being muddied by terms such as "helicopter money" and "people's QE" being bandied about with little thought as to what they are, or whether they really would meet the current need. So I want to start by clarifying what, in my view, these terms mean.

In my book, I defined "people's QE" to mean two different things:

  • direct cash transfers to people and businesses
  • central bank financing of government expenditures

Note that these are both flows. Any form of QE inevitably monetises part of the stock of government debt, but this is not primarily its purpose. Bonds bought by central banks, and money distributed by central banks, remain on the public balance sheet. So both of these alternatives expand the balance sheet of the central bank and, usually, mean an increase in public debt. Public sector debt jubilee requires separate consideration and in my view is not the most urgent need.

Direct cash transfers to households and businesses, and central bank financing of government cash transfers to households, are both colloquially known as "helicopter money". It's tempting to imagine the first of these as helicopters dropping pound coins over say, Milton Keynes, and the second as helicopters dropping them over Whitehall. But in reality, in both versions helicopters fly over Milton Keynes. And although in the first version the helicopter has "Central Bank" in large letters on the side, and in the other version it has "Government" on the side, the personnel flying it are the same in both cases. The difference between direct central bank cash transfers and central-bank financed government cash transfers is the purpose for which the helicopter drops are intended, and therefore, where the helicopters fly.

Emergency government cash transfers, such as the US's $1200 cheques, are primarily intended to relieve hardship. This is true even if they are central bank financed. They usually go to those most in need of money, and they can go to businesses as well as households. Central bank cash transfers, on the other hand, are primarily intended to raise aggregate demand. They work best if they are directed to those with the highest marginal propensity to spend, and therefore can have the effect of relieving hardship, but that is not their primary purpose.

There is an immediate, and I hope obvious, problem with a central bank giving direct cash transfers to businesses that are on the verge of failure. That is credit risk. We have no way of knowing whether businesses that are failing would be viable in other circumstances, or indeed whether they will survive for long after the lockdown. So the central bank would provide liquidity to businesses of questionable viability, presumably without collateral (since many of the businesses in trouble have little in the way of assets) and for indefinite periods of time. It would in effect be disguised government bailout of these companies - even more so were the central bank to take equity stakes, as some have proposed. I would suggest that this assistance should more properly come from the fiscal authorities.

There is a related problem with the idea of the central bank giving emergency cash directly to distressed households. The payments would have to be large enough for households to maintain fixed commitments such as mortgage interest payments and rent. So it would be a disguised bailout of banks and landlords. If the payments were indiscriminate, it would also involve giving a lot of money to people who not only don't need it, but at the moment have no means of spending it. And if the payments were targeted to people in need, then the central bank would be doing welfare payments. Again, I would suggest that this assistance should more properly come from the fiscal authorities.

But there are deeper problems with the central bank giving direct cash transfers to households and businesses during a lockdown. The purpose of central bank stimulus is to raise aggregate demand and thus return inflation to target. Helicopter money is a powerful tool for achieving this in a normal recession. But in an engineered shutdown, when the government has ordered large parts of the supply side to close down or restrict its activities, stimulating aggregate demand is surely the last thing we need. Staying alive is the imperative.

Some may think distinguishing between aggregate demand stimulus and giving emergency cash to distressed households and businesses is specious. After all, giving emergency cash supports aggregate demand, doesn't it? But in my view this distinction is crucial. If the purpose of your direct cash transfer is to raise aggregate demand, then it doesn't matter if some people don't get the money, or if others save it. You only need a majority to spend the money for aggregate demand to move in the right direction. But if your purpose is to relieve hardship, then it does matter if the people in the greatest need are unable to benefit from the transfer, while others who are not in need receive it. It matters for public accountability. It matters politically, since such a scheme would be widely seen as unfair. And it matters socially, since hardship would not be effectively relieved. Central banks got into enough political hot water with the perceived unfairness of QE. They need to stay well away from this steaming quagmire. But that doesn't mean they can't support governments.

The time has come for the second type of "people's QE", namely central bank financing of government expenditures. Keeping people and businesses alive in a pandemic is extraordinarily expensive, not just because of the necessary cash transfers, but also because of raised expenditure on health services. Because central banks can create money without limit, they have unlimited buying power in their own currencies. When this power is made available to governments, they can finance the extraordinary expenditures that are needed today without fear of "buyers' strikes" and debt crisis.

The primary remit of central banks is price stability, and since 2008 they have also taken responsibility for financial stability. At present, inflation is heading fast into negative territory, and there is a serious risk of debt deflation unless failing businesses and distressed households are provided with emergency liquidity. I've already explained why the central bank refloating these businesses and households directly is the wrong solution. But if central banks are to come anywhere near meeting their mandates, they must do "whatever it takes" to support governments so they can make the exceptional payments needed by households and businesses. In this situation, close cooperation between central banks and governments is desperately needed.

Central banks can and should buy their own governments' debt without limit, suppressing yields and thus preventing debt crises such as we saw in 2012. Central banks can provide banks with unlimited liquidity and amend regulatory requirements to ensure they continue to support businesses and households. They can intervene in markets to keep them functioning and prevent damaging volatility. In the present crisis, they can and should lend directly to their governments to smooth cash flow and prevent sudden large bond issues disrupting fragile markets. All of this, I would suggest, is within their price and financial staiblity mandates.

In the last decade, we have seen central banks provide a monetary shield for governments hell-bent on hurting certain sections of their own populations. They are now called upon to provide a monetary shield so that governments can protect their populations and their economies from the effects of a very nasty virus.

Of course, central bank financing of government expenditure is widely feared because of its historic association with hyperinflation. The fact that many governments have historically made considerable use of their central banks' lending capacity without generating significant inflation gets lost in the shouts of "Zimbabwe!" But this is the deepest slump since the 1930s. The hyperinflation risk is minimal. And if this crisis could once and for all lay to rest the notion that central banks providing governments with the money they need to finance exceptional expenditures in a deep slump is necessarily highly inflationary, that would be a good thing.

Once restrictions have been lifted sufficiently for households to start spending again, central banks might want to consider doing direct cash transfers to households as well as financing government expenditures. Evidence from China is that consumer confidence remains low for some time after restrictions are lifted, and there is also evidence from several countries now that lockdowns may need to be reimposed. This adds up to a long-running demand slump, which could be relieved by direct cash transfers to households after the immediate emergency is over or in the gaps between successive lockdowns.

But whether direct cash transfers are done now or later, the distribution mechanism needs a radical overhaul. The crisis has shown us just how difficult it is to get money to people. Governments have come up with a multitude of schemes, and yet people drop down the cracks between those schemes. The people who most desperately need money are also the most difficult to reach. And government policy can completely exclude some vulnerable groups, such as migrants.

There is an urgent need for a universal payments mechanism that can deliver money to people and businesses fast and efficiently in a crisis. Welfare systems that deliberately create obstacles to obtaining money are incapable of doing this, and systems that deliver money to households rather than individuals are open to abuse. One solution might be to establish an unconditional universal basic income, not as crisis relief but as infrastructure.

Using UBI as crisis relief fails for the reason I have already given: it is by design insufficient for people who are used to earned income, and therefore could not remove the risk of debt deflation unless the payments were raised to extremely high levels, exceeding the earned income of many people and thus creating a real disincentive to work, with potentially highly inflationary consequences. I say this as a supporter of UBI: I don't want to see it misused like this!

But a low UBI would create a permanent mechanism through which emergency cash payments from fiscal authorites and direct cash transfers from central banks could both be delivered. Governments and central banks use the same helicopters.

So rather than arguing about whether there should be cash transfers, and to whom they should go, and when, we need to concentrate on setting up a reliable mechanism that both governments and central banks can use to distribute money. There are a lot of ideas:

  • central bank accounts for individuals, and potentially also for businesses
  • central bank digital currency delivered to individual wallets
  • secure pre-paid cards, delivered to vulnerable people through agencies working with those people
  • perpetual loans delivered via banks
  • physical cash, delivered via banks or post offices on production of ID
  • deliveries to household bank accounts by reversing local tax systems or utility payments (since local authorities and utilities often have better records of households than central government does) 
  • forcing banks to create basic bank accounts for everyone

Most of these carry implications for privacy. Not everyone wants to have a bank account, and not everyone has ID. Governments need to find ways of getting money to people on the margins of society. But this is not really the responsibilty of central banks. If they are to maintain their independence, then they cannot get involved in discussions of who should be entitled to receive money and at what price, except in so far as restricting the distribution of money impacts their own mandates.

Finally, some consideration needs to be given to the role of central banks in an interconnected and dollar-dependent world. The Fed seems now to have accepted its role as dealer-of-last-resort for the world, but so far there is no coordinated central bank action to ward off FX crises in developing countries. Yet debt crises in developing countries have a nasty habit of coming back to bite the developed world. As John Donne had it, "every man is a piece of the continent, a part of the main; if a clod be washed away by the sea, Europe is the less".

It is surely within the mandates of developed country central banks that they do "whatever it takes" not only to support their own governments, but also to prevent a global depression.

Related reading:

When is the right time for UBI and helicopter money?
Is "helicopter money" the answer to the looming economic crisis? - Open Democracy
Central banks and coronavirus
The case for People's QE
How Central Banks could use digital cash to deliver universal basic income - Coindesk

Image of the Bank of England from Wikipedia.