The QE Ratchet

When it comes to quantitative easing (QE), where you stand most definitely relies on where you sit. That is among the findings of the brand-new report of the Economic Affairs Board of the Committee of the UK House of Lords.

The report offers a superb survey of how it is that central banks currently use their balance sheets. They reached the following conclusions: Firstly, central banks ought to clearly communicate the reasoning for their balance sheet actions, explaining what they are doing and why. Secondly, policymakers should offer even more information on their estimates (and uncertainties) of the effectiveness of their numerous activities, specifically QE. Thirdly, they must be aware that the connection between the central bank balance sheet policy and government debt management policy threatens independence. Lastly, and most importantly, central bankers require an exit plan for exactly how they will return to a long-run to a long-term sustainable level for their balance sheet.

Stephen G. Cecchetti, Rosen Family Chair in International Finance at the Brandeis International Business School, and Kermit L. Schoenholtz,  Henry Kaufman Professor of the History of Financial Institutions and Markets in the Department of Economics of New York University’s Leonard N. Stern School of Business, suggested that central bankers should be transparent about their reaction function for balance sheet policies and interest rate. They emphasized the need for simple and clear explanations to the policymakers’ goals, carefully distinguishing between the intended purposes (such as emergency government finance, monetary policy, lender/market maker of last resort, or emergency government finance). Furthermore, regarding the relationship between QE and fiscal finance, they remarked how the ballooning of the US Treasury’s balance at the Fed in the earlier stages of the pandemic seemed like monetary finance, threatening independence. 

Cecchetti and Schoenholtz take on the challenge that Lord King highlights in the opening quote: the demand to guarantee that central banks do not perceive bond purchases as a solution for every issue that falls the economic and the financial system, leading their balance sheets to repeatedly ratchet upward.

Central banks were initially developed to finance the government. Afterward, they came to be lenders of last resort to maintain the banking system. What they understand as conventional monetary policy – using interest rates to achieve price stability with full use of the economy’s productive resources-became the most noticeable activity of central banks only after the second world war. About 30 years back, a broad consensus arose that central banks should be independent of fiscal authorities, block direct government finance, and have a clear inflation objective.

The financial crisis of 2007-09 caused one more collection of changes. To stabilize financial markets, central banks augmented both the scale and also the range of their activities. The list of actions is lengthy. To choose a few, the Fed agreed to offer dollars to various other central banks, lend to sustain dealers in their bond market-making tasks, as well as create a set of special function vehicles to directly buy assets (like commercial paper).

In all these financial stabilizing initiatives, which included a combination of loaning and market production, balance sheet quantities rose momentarily before going back to zero (or nearly zero). The chart below of the Federal Get dollar liquidity swaps is representative. The level went dramatically up and afterward swiftly down on three different situations. The Lehman bankruptcy in late 2008 set off the initial and most significant and episode. The second peak came during the euro crisis in mid-2012. And also, the 3rd is in April 2020, during the economic tension that came with the pandemic’s beginning. In each instance, there is a spike-the quantity provided dives and then drops. One can likewise see this spike pattern-where Fed holdings or loans rise and then plummet in lending to primary dealers, liquidity provision to support financial market mutual funds, commercial paper holdings, and a collection of others.

Central bank dollar liquidity swaps (weekly, billions of dollars), 2007-2021

Nevertheless, the balance sheet path is fundamentally different for monetary policy actions aimed at easing financial conditions to stimulate aggregate demand. The chart below shows Federal Reserve holdings of securities minus currency outstanding. (Growth in US dollar in circulation needs the Fed to increase its assets even if all other central bank responsibilities are held constant, so they eliminated that.) Notice that the sustained use of balance sheet tools is closely related to the effective lower bound on nominal interest rates: when central banks lacked conventional interest rate space, they turned to other means.

Federal Reserve securities held outright minus currency in circulation (month-end, trillions of dollars), 2007-July 2021

The ratchet effect surges once balance sheet policies become the standard. Significant quantities rise significantly and afterward fall modestly before rising once more. For the Fed, the initial step-up took place in 2009, increasing non-currency associated holdings above $1 trillion. From October 2010 to July 2011, step two drove the level to $1.6 trillion. From December 2012 to September 2014, step three improved securities minus currency to $2.9 trillion. Lastly, step 4-easily the biggest-reflects the Fed’s action to the pandemic and its after-effects. At this writing, the Fed holds $7.6 trillion in securities, and $2.2 trillion in money is exceptional, so the total amount in the chart is $5.4 trillion. But, given that Fed purchases are continuing at a rate that greatly exceeds the money growth rate, we do not know when this will stop.

Why exists a ratchet? Where does it originate from? One possible explanation is ingrained in the observation that the influence of asset purchases on financial conditions and accumulated demand is limited. Research created outside central banks indicates that there may be no influence in all. To be sure, large-scale asset acquisitions likely have a substantial effect when there are dislocations in markets that protect against arbitrage. Yet when markets are functioning well, which is the majority of the time, purchases might run only by increasing the credibility of central bank forward guidance. From the point of view of aggregate demand management, this “signaling only” effect means there is slight short-term risk of doing it excessively and a tangible incentive to err on the side of doing a lot more. A 2nd cause of the ratchet is the one Lord King highlights in the opening quote: the idea that central banks can mitigate the effect of bad news on the financial system and the real economy by getting even more bonds.
Now, central banks are not only routinely ratcheting higher, but the range of their actions is considerably wider. Focusing again on the Fed, the pandemic led to interventions in corporate bond markets, municipal bond markets, and bank business lending. In the majority of cases, the totals continue to be relatively small, a little over $30 billion for all credit facilities combined, and the facilities are now unwinding. However, the same can not be stated of mortgage-backed securities, where Fed holdings augmented by $1 trillion over the past 18 months and continue to increase.

We see various threats in expanding the central bank balance sheet’s scope and range. First, Cecchetti and Schoenholtz, in an earlier post in Money and Banking, wrote that to ensure that central banks maintain the independence to do well what they are made to do, we need to enforce clear limits on the scope of what they are authorized to do, limiting both what they can purchase outright and to whom they can lend. As of now, many individuals believe that, regardless of circumstances, central banks can stabilize any market, rescue any borrower, and neutralize any negative economic or financial shock. This is not true.

Second, to guarantee the sustainability of their balance sheets, central bankers need to avoid the QE ratchet. This means supplying transparent guidance on their view of a typical balance sheet (size and expansion pace) and exactly how policymakers intend to reach there.

For example, the Fed hopes to provide reserves pleasantly (yet not excessively) above the level required to keep the overnight rate of interest near their target without frequent open-market operations. September 2019 hinted at what scale could fit this “ample reserves” regime. From January 2018 to September 2019, the Fed contracted its securities holdings by $650 billion, permitting commercial bank reserves to fall by almost $800 billion. In hindsight, they went too far since the overnight Treasury repo rate spiked to 6% on September 17. From this experience, without structural or regulatory modifications to the financial system, one could conclude that the level of securities minus currency in summertime 2019-something in the span of $2 to $2 1/2 trillion-is close to the sustainable level. (For reserves, the level is most likely in the range of $1 1/2 to 1 3/4 trillion, less than one-half the existing $4 trillion).

Returning to the UK House of Lords report, Cecchetti and Schoenholtz agree with the core message that QE has gone askew. With time, central banks will need to pull back. More promptly, they need to provide more clarity on how they connect their balance sheets actions quantitatively to financial conditions and accumulate demands. Most notably, policymakers are required to inform how they will exit when they near their inflation and employment goals.

According to Cecchetti and Schoenholtz, the central banks should address the following questionings: What will drive you to stop purchasing securities? What conditions will drive you to sell securities? What is the long-term normal and sustainable size of your balance sheet? In normal circumstances, how quickly will your balance sheet grow? When economic stability is back, exactly how quickly will you shrink it back to the normal level?

Any response to these concerns will undoubtedly be conditional to change since the economic and financial environment evolves. But policy planning is invariably conditional, so it is expected that the explanations will be, as well.

Originally published on Money and Banking. Read the original article.