Breaking Bad Bond Purchase by Andrés Velasco
It’s understandable for a central bank to print money to buy assets at the height of a financial crisis. But pursuing such policies in conditions of relative tranquility makes little sense – and raises serious risks.
LONDON – Ahead of the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming, last month, discussion focused on whether monetary policy is expected to be tightened in response to rising US inflation. By suggesting that asset purchases would be cut first and interest rate hikes would come much later, Fed Chairman Jerome Powell shifted the conversation to the question of How? ‘Or’ What policy needs to be strengthened.
While printing money to buy bonds and cut long-term interest rates is justified in crises like those of 2008 or 2020, sustaining quantitative easing (QE) in calmer times is far from over. be obvious. To see why, it helps dispel three misconceptions about QE.
The first misconception is that QE is monetary policy. It’s not. Or rather, it is not only this. It is also a fiscal policy. In each country, the central bank belongs to the Treasury. When the Fed issues money – central bank reserves, in fact – to buy a government bond, the private sector gets one government bond in exchange for another.
The second misconception is that the government (including the Treasury and the central bank) always comes out on top in such a transaction, because the private sector ends up with a security that pays a lower interest rate. It doesn’t have to be that way. Central bank reserves can only be held by commercial banks, which have limited use of them. To get banks to hold more reserves, central bankers have to pay interest, as the Fed and the Bank of England began to do in response to the 2008 financial crisis.
The third misconception is that whenever the interest rate on central bank reserves is zero or lower than the rate on government bonds, the government can spend what it wants, when it wants. This is the central principle of modern monetary theory. It’s concise, breathtaking, elegant, and false.
Yes, financing by monetary creation (economists call this seigniorage) is possible when the return on money is lower than that of government bonds. But as the central bank prints more and more money, it has to pay increasingly higher interest rates on that money to ensure that commercial banks and the public will want to hold it. Sooner or later the interest rate gap closes and there is no more seigniorage to be had. If the central bank continues to print money beyond this point, the private sector will start to throw it away, causing currency depreciation, inflation, or both.
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Once these three conditions are accepted, we have to ask ourselves the several trillion dollar question: does QE make sense, from a fiscal point of view, in the United States today? The answer is no, for at least two reasons.
At the end of August 2021, the Fed was paying 0.15% interest on commercial bank reserve balances at a time when the interest rate on short-dated Treasuries hovered around 0.04%. This means that it is cheaper (for the US taxpayer) to finance expenses by issuing bonds than by printing money.
It may seem paradoxical. But it’s important to remember that return is an approximation of liquidity. Fed reserves can only be held by banks. They do not serve as collateral and are subject to capital requirements. Treasury bills, on the other hand, can be held by anyone. They are traded in a huge and deep market and are commonly used as collateral for other financial transactions. No wonder investors view Treasuries as more liquid and ask them for a lower yield.
Another reason why additional QE makes little fiscal sense is debt maturity. Treasury bonds have many maturities, ranging up to 30 years. But the unrequired portion of the Fed’s reserves has only one maturity: instantaneous (since commercial banks are free to withdraw them at will). So every time the Fed issues reserves to buy a long-term bond, it lowers the average maturity of government debt.
If interest rates on long-term treasury bills were high, such a policy would make sense. But the oft-cited ten-year Treasury rate today is significantly lower than the Fed’s target inflation rate for that period, implying that people around the world are effectively paying for the privilege of handing their money over to the U.S. government. for the next ten years. years.
Under these circumstances, as Lawrence H. Summers recently argued in the Washington post, the good policy is to “extinguish” the public debt – by locking in the rates very low as long as possible – and not to “extinguish” the debt as the Fed does with QE. A government here is like a family looking to take out a mortgage: the lower the long-term rates, the longer it makes sense to borrow.
The acquirer analogy also sheds light on the other risk introduced by short maturities: exposure to future rate hikes. In the United States, where 30-year fixed-rate mortgages are common, a new homeowner doesn’t have to worry about what the Fed will do with interest rates next year – or even over the next year. next two decades. But in the UK, where adjustable rate mortgages are the norm, homeowners are still worried about what the Bank of England will do next.
In managing its debt, the US federal government has followed the lead of the UK owners. While interest rates won’t rise tomorrow, they certainly will someday, and when they do, rolling over huge stocks of debt at higher yields will come at a sizeable fiscal cost.
We can also imagine a bad financial dynamic at work: a growing interest charge leads to an increase in debt issuance, and this increase in supply reduces the liquidity premium on new bonds, further increasing rates. interest rate and requiring ever larger bond issues.
In addition, unsavory political dynamics could emerge. When central bank decisions have a big impact on public finances, politicians will be more inclined to coax central bankers into keeping rates low. Skeptics will argue that this sort of thing does not happen in the United States. But the former US president was not shy about bullying the Fed via Twitter, which was not supposed to happen. (Presidents like Donald Trump weren’t supposed to arrive either.)
These are not arguments for a more restrictive monetary policy; the Fed can keep the short-term interest rate as low as needed. Nor are they arguments in favor of a more restrictive fiscal policy; if the Biden administration wants to spend more, it can issue long-term bonds or raise taxes. Printing money to pay the deficit was once the progressive thing to do. Not anymore.