Central banks may have to rethink or even get rid of one of their most important emergency tools because people are getting angry about big cash transfers to commercial banks while interest rates go up, the recession gets worse, and the Treasury’s funds run out.
The stakes are high because it could affect how extraordinary monetary policies like bond-buying “quantitative easing” (QE) are used and how well they work in the future. It also calls into question the political independence of central bank policymaking in general.
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The European Central Bank, the Bank of England, and the U.S. Federal Reserve are all now dealing with the effects of years of policy-driven, but profitable, balance sheet growth. As they raise interest rates, that balance sheet burns a hole in their pockets, or more specifically, the pockets of their governments, which have been used to getting money from the other side for a long time.
It’s the flip side of more than a decade of bond-buying QE, which started to get around the limits of near-zero policy rates when fears of deflation were high. In exchange for the bonds, banks were given trillions of dollars in interest-bearing reserves.
With rates going down or getting close to zero, central banks made money by switching to higher-yielding bonds, paying almost nothing for commercial bank reserves, and giving the money they made to governments to spend.
Now that they have to sharply raise interest rates before reducing their balance sheets, which have grown even bigger because of support for pandemics, the banks are going to make a lot of money while payments to the Treasury slow down or even stop.
The fact that these payments are going to banks while taxpayers are on the hook could be bad for politics.
“Paying billions to banks for holding the safest form of liquidity could lead to criticism from the public,” Axa Group Chief Economist Gilles Moec wrote. He added that it could be seen as “unnecessary support” when rising rates already raise banks’ net margins and the public purse is under pressure from a series of shocks.
This has been a problem for Britain all year.
After giving the Treasury about 120 billion pounds in profits over 13 years, the Bank of England made its first loss for the public finances last month, a 156 million pound loss from its bond portfolio compared to the interest paid on reserves. This is the first loss for the public finances since the bank started its QE programme in 2009.
By May, the Bank of England (BoE) is expected to at least double its policy rate, which is the rate paid on bank reserves. This will cause that number to go up. Paul Tucker, who used to be the BoE’s deputy governor, asked the central bank this month to limit the rate it pays on these reserves. He said it could save the government about 40 billion pounds, which it needs for its revised budget statement on November 17.
And since the Fed sent more than $100 billion to the Treasury just last year, its net income turned negative in September and will stay that way for a while as reserve payments go up.
On Thursday, the ECB might say how it plans to pass the test.
WAR AND PEACE
The ECB is expected to address how its rising deposit rate lets commercial banks use the central bank like an ATM, “round-tripping” emergency funding facilities with rates now lower than those earned by just depositing the cash back at the ECB.
ECB watchers think that a solution could be some kind of “reverse tiering” of the payment of reserves related to amounts taken in so-called Targeted Long-Term Refinancing Operations (TLTROs), which make up about a quarter of the ECB’s balance sheet.
Even though that might end up being the best choice, it comes with a lot of problems, like setting a precedent for changing the original terms and conditions of the TLTRO loans, which could make them harder to get and less useful if they are needed in a future recession or other shock.
Erik Nielsen, an economic adviser at Unicredit (BIT: CDI), called that choice “a very difficult path.”
Simon Freycenet, a rates strategist at Goldman Sachs (NYSE:GS), thinks that changing the TLTRO terms to bring the funding rate closer to the ECB deposit rates was probably the “least complicated solution,” but it had “clear disadvantages in terms of future policy and legal risks.”
The cost of doing nothing is almost too high to be a choice. Axa’s models show that if ECB rates go up to their expected peak of 3% next year, there would be a shock from excess reserves that would drop the fiscal balance in the euro zone by 1% all at once.
All of this shows the direct fiscal effect of QE monetary policy, which many people feared would make it hard to get out of QE when policy rates need to spike hard to cool inflation. This would threaten the independence of central banks and their mandate to only focus on price stability, since political and budget pressures on governments require them to do something else.
Rogoff, who used to be the head economist at the International Monetary Fund, said again this week that the Fed should have thought about negative interest rates instead of doubling down on a QE programme that is now harder to stop politically.
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Rogoff wrote in Foreign Affairs, “I wonder how ready voters are for yet another deep recession, given how much they complain about inflation.” “The political and economic landscape has changed so much that it seems unlikely that the Fed will choose to bring inflation back to where it was before the pandemic and keep it there for a long time.”
Nobel Prize winner Joseph Stiglitz thinks that the political needs of the war caused by Russia’s invasion of Ukraine, which is at least partly to blame for the rise in inflation and interest rates this year, should be more important than narrower market goals and should win out over opposition to windfall taxes, just as they have in all major wars in the past.
In a Project Syndicate blog, he said, “It is a mistake to think that the war can be won with a peacetime economy.” “In a serious war, no country has ever won by leaving markets alone.”
These are the thoughts of the author, who writes a column for Reuters.
(By Mike Dolan, @reutersMikeD on Twitter.) (Nell Mackenzie wrote the story, and Paul Simao edited it.)
