The New Unannounced Monetary Policy

Massive changes in monetary policy in the United States and the United Kingdom have occurred since the middle of March, when the seriousness of the coronavirus epidemic was becoming apparent. The changes have not been fully explained by either central bank, let alone justified.

What is clear is what the central banks have actually done, which has been faithfully reported. The main features are:

1. Enormous purchases of government bonds, exceeding the rate of sales by government financing agencies (Allen 2020).

2. Facilitation of finance to private borrowers, e.g. by purchases of privately issued bonds.

3. In the Fed’s case, provision of dollar funding through swap facilities to foreign central banks, for on-lending to commercial banks outside the United States.

The second and third devices were used during the financial crisis of 2008, but there were no purchases of government securities then.

As I argued in an earlier paper (Allen and Moessner 2020), the actual and potential scale of central banks’ purchases of government bonds gives them control over bond yields. They therefore, simply as a matter of logic, need to make decisions about what levels of yields they want to prevail. They have not yet acknowledged this logic, or said anything about desired levels of yields. In practice, the operations of the two central banks have had the effect, intended or otherwise, of perpetuating the yield levels that prevailed before the pandemic.

The statements of the two central banks both referred to the need to maintain market functioning.  Fed Vice-Chairman Randal Quarles noted on 6th February that liquidity in the U.S. Treasury securities market had deteriorated and that the Fed was considering what it could do to address the issue. Liquidity evidently deteriorated further as the pandemic emerged, and the Fed’s solution took the form of its massive purchases. The action was analogous to the ‘market maker of last resort’ actions that the Fed undertook in 2008.

Making a market does not, however, imply maintaining the price unchanged whatever the circumstances. Market makers buy and sell. Central banks have only bought. Central banks have a history of pegging bond yields. For example, bond yields were pegged during the Second World War in both countries, and the pegging was reinforced by controls on private borrowing. The purpose was to keep down the cost to the government of financing the war. It was an unacknowledged and perhaps, at the time, unrecognised consequence that some of the cost would ultimately be borne by bond investors as the real value of the debt was subsequently eroded by inflation. Both the United States and the United Kingdom persisted with the policy of keeping bond yields low long after inflationary pressures had emerged. More recently, the Bank of Japan has pegged 10-year government bond yields.

Central banks may think that the current ultra-low levels of bond yields are part of the monetary policy appropriate to the current situation. It should be noted that, if so, they are implicitly forecasting that short-term interest rates will need to remain very low for a very long time, lasting for decades. If they do not believe that forecast, then keeping bond yields low now represents a form of time-inconsistency.

Central banks may also be concerned about financial stability issues. Specifically, a loss of liquidity in government securities would probably imply a loss of liquidity for many other assets and many financial institutions. There would probably be a rush to get out of assets thought to be in danger of illiquidity, collapses in their prices, and perhaps widespread bankruptcies. It is possible that central banks and perhaps government debt management agencies fear that a sudden rise in yields might mean heavy losses for commercial market makers and traders in government securities, and further impair the liquidity of the market. That would be a legitimate concern, since a loss of liquidity in government securities markets would also create problems for the financing of government deficits, which even an independent central bank could not ignore. It would be in the public interest to pay a price to maintain liquid markets in government securities. But buying everything that investors want to sell at existing prices is an unduly expensive way of maintaining a liquid market; moreover it will be unsustainable if the existing prices are not in line with the market equilibrium.

Both monetary policy and financial concerns are apparent in the comments of the Bank of England Monetary Policy Committee member Gertjan Vlieghe on the MPC’s decision on 19th March to extend its quantitative easing programme:

‘But as financial conditions deteriorated further, with some market stress indicators approaching levels last seen during the financial crisis, market functioning began to deteriorate more rapidly in the week of 16 March, even in government bond markets. Amid increasing signs of market dysfunction, government bond yields began to rise. The rise in yields was driven by real yields, not a rise in inflation compensation, even as risky asset prices fell further. The change in the real yield curve on 18 March was the largest one day change since the Bank of England independence in 1997, for maturities beyond five years…This rise in yields occurred with most liquidity indicators deteriorating rapidly, and bid-ask spreads in long-term bonds higher than during the global financial crisis…. On their own, each of these developments might not necessarily have needed an immediate policy response, but taken together, they risked an unwarranted tightening in financial conditions and therefore a policy response was warranted.’

The head of the U.K. Debt Management Office has confirmed that the Bank of England’s decision was a response to the drying-up of secondary market liquidity. Mr Vlieghe’s speech and Sir Robert Stheeman’s interview are the only official accounts of current policy that I have been able to find.

Central banks have done more than simply maintain liquidity in government securities: they have also perpetuated current yield levels. As already noted, it is possible that this reflects a considered monetary policy judgment. The monetary policy mandates of the central banks have not changed, but the connections between the new policies and the mandates have not been fully explained. The reason for the central banks’ lack of clarity is probably that they have not clarified their own thinking, and are in some degree making it up as they go along. The need to do so is unavoidable, even though it is an unfamiliar and probably unpleasant procedure. A candid exposition of the issues would be very welcome.

For further reading please see NIER No. 252 Commentary by Jagjit Chadha, Monetary policy in troubled times