Government finance

The QE Ratchet

When it comes to quantitative easing (QE), where you stand definitely depends on where you sit. That is among the conclusions of the important new report of the Economic Affairs Committee of the UK House of Lords.

The report provides an excellent survey of how it is that central banks now use their balance sheets. Its key conclusions are the following. First, central bankers should clearly communicate the rationale for their balance sheet actions, stating what they are doing and why. Second, policymakers should provide more detail on their estimates (and uncertainties) of the effectiveness of their various actions, especially QE. Third, they should be aware that the relationship between central bank balance sheet policy and government debt management policy poses a risk to independence. Finally, and most importantly, central bankers need an exit plan for how they will return to a long-run sustainable level for their balance sheet.

We discussed several of these points in prior posts. On communication, we argued that central bankers should be clear about their reaction function for both interest rate and balance sheet policies (see here). On the justification for policymakers’ actions, we emphasized the need for clear, simple explanations tied to policymakers’ objectives, distinguishing carefully between the intended purposes (such as monetary policy, lender/market maker of last resort, or emergency government finance; see here). And, on the relationship between QE and fiscal finance, we noted how the ballooning of the U.S. Treasury’s balance at the Fed in the early stages of the pandemic looked like monetary finance, putting independence at risk (see here).

In this post, we turn to the challenge that Lord King highlights in the opening quote: the need to ensure that central banks do not see bond purchases as a cure-all for every ill that befalls the economy and the financial system, causing their balance sheets repeatedly to ratchet upward….

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Central Bank Digital Currency: The Battle for the Soul of the Financial System

While the conflict is largely quiet and out of public view, we are in the midst of an epic battle for the soul of the financial system. Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable.

The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilization can lead to a very unstable global system that thwarts monetary control.

Central bank digital currency (CBDC) can take many forms. While some may be benign, the most radical version—one that is universally available, elastically supplied, and interest bearing—has the potential to trigger destabilizing financial shifts, weaken the supply of credit, and undermine privacy….

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Understanding How Central Banks Use Their Balance Sheets: A Critical Categorization

This comment is jointly authored by Stephen G. Cecchetti and Sir Paul M.W. Tucker.

Central banks have been reinvented over the past decade, first in response to the financial crisis, and then as a consequence of Covid-19. While trying to maintain monetary stability and promote economic recovery, their balance sheets have ballooned. In 2007, the central banks in the United States, euro area, United Kingdom, and Japan had total assets from 6% to 20% of nominal GDP. By the end of 2020, the Fed’s balance sheet was 34% of GDP, the ECB’s 59%, the Bank of England’s 40%, and the Bank of Japan’s 127%.

Before it is possible to consider how well this worked, it is necessary to be clear about what policymakers’ various operations were trying to achieve. Headline declarations of aiming at “price stability” or “financial stability” are unsatisfactory as they jump to end goals without attending to the motivations for specific operations and facilities. The case of the Fed is illustrative. Among other things, they bought U.S. Treasury bonds, offered to purchase commercial paper, corporate and municipal bonds, and set up facilities to lend directly to real-economy businesses as well as to securities dealers. These cannot be assessed solely on whether, alone or together, each materially improved the outlook for economic activity and inflation.

Without a sense of the intended purpose of each central bank action, it is difficult for political overseers or interested members of the public to hold central banks accountable. Precisely because central banks are independent (rightly in our view), that accountability takes the form of public scrutiny and debate. But we argue that it is also hard for central bankers themselves to do their jobs unless they distinguish carefully—in internal deliberations, and external communication—the rationale for different interventions….

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Helicopters to the Rescue?

Is helicopter money here? Do we need it now? Is it coming? The short answer to these questions is that it is not here and we currently do not need it, but should the economic disaster brought on by COVID-19 continue for much longer, that might change.

To be clear, the relief checks that governments are sending out to households and businesses are not helicopter money. Despite their enormous scale, the financing of these transfers is no different in character from that of traditional government benefits: governments are collecting taxes and issuing debt to the public.

Helicopter money is when the central bank finances government expenditure directly. In these circumstances, the fiscal authority, through its debt management policies, controls the size of the central bank’s balance sheet. This is monetary finance arising from fiscal dominance: to increase seignorage, the fiscal authority usurps the role of the independent central bank in determining the size of base money (currency plus reserves held by banks at the central bank).

Should monetary policymakers consider surrendering their independence in this way? In our view, a far better alternative is to peg the long-term interest rate at zero. Currently in use by the Bank of Japan, this policy of yield curve control allows central banks to retain a small, but significant degree of monetary control. It also captures the features of U.S. monetary policy from 1937 to 1951, when the Fed capped the long-term bond yield to support U.S. wartime finance (see here)….

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