Central banks and large scale asset purchases
With COVID-19 causing concerns, the RBNZ announced to cut the official cash rate to 0.25% on 16 March. Given this the OCR is at a low level now- leading to open consideration of other potential “unconventional tools” such as Large Scale Asset Purchases (LSAP) or more commonly termed as Quantitative Easing. With this now taking place around the world I wanted to discuss these tools.
Upfront I want to note that monetary policy doesn’t do anything to prevent a pandemic – so the main purpose of most of these tools in the short term is to ensure liquidity and avoid the insolvency of firms and financial institutions that would be solvent in the long-term.
But coming out of the pandemic the ability to “boost demand” will be important in the future- so having an idea about how the tools can fill that aim when the time comes is useful.
Background
To support the economy during the pandemic, last Sunday, the Fed cut the interest rate to around zero. Alongside this the Bank of Australia announced it will start bond purchased (with more monetary policy announcements today) while US dollar liquidity swap line arrangements had their maturity increased and swap price decreased, with the Bank of Japan already utilising this.
Of course, New Zealand was not outside of these events. The Reserve Bank called an emergency meeting on Monday for a 0.75 percentage point reduction in the OCR to 0.25 percent. This was combined with delays to the planned increases in capital requirements, changed the margins in settlement cash and repo accounts to increase liquidity, and reopened the Term Auction Facility. Furthermore, this monetary policy response was supplemented with a date-contingent forward guidance (with 12 months commitment of keeping the OCR at the same rate).
However, unlike the standard view of forward guidance which is focused on committing to keep interest rates low this had a second objective – it ruled out the possibility the Bank would cut rates and introduce a negative rate OCR over the next twelve months. They noted that this forward guidance would give stability, but if they can’t cut rates further what do they do if they need to stimulate demand more?
For future stimulus, it was explicitly indicated that large scale asset purchases (LSAP) of government bonds was the preferred tool to apply as a part of the unconventional monetary policy – a change in tune from prior announcements, likely based on what is currently viewed as administerable in a timely fashion.
In this way, we appear to be in the middle of the “six unconventional monetary policy tools” I have written about earlier.
In this post I want to discuss LSAP.
On Large Scale Asset Purchases
What is LSAP? Alternatively termed as Quantitative easing “is a monetary policy whereby a central bank buys predetermined amounts of government bonds or other financial assets in order to add money directly into the economy”.
This method is used when the central bank hits zero lower bound of the interest rates, and decides to undertake other “unconventional” methods to stimulate demand. In my write up on unconventional tools I describe QE/buying government bonds in the following way:
Buying government bonds.
This relates to the idea of Quantitative Easing. Purchasing government bonds stimulates activity in three ways:
- Swapping a liquid asset for an illiquid asset,
- Driving down yields (and up asset prices) for a private asset
- Making it costly for the central bank to increase rates to quickly – thereby making forward guidance “credible”.
If the central bank buys directly from Treasury, or arguably holds the bonds to maturity, then this can be seen as a form of “monetizing debt”. However, if they buy assets and then sell them back in the future it is not!
As a result, such purchases can be seen as simply “open-market operations” of the form central banks used to set policy through. And when “monetization” occurs consistent with broad central government and central bank coordination during a zero lower bound episode.
There are two ways of reading this:
Firstly, the government sells bonds to private agents, the central bank then buys them from private agents. This is standard QE which occurs through secondary markets.
The advantage of this form of doing QE is that it is transparent, and provides market information about inflation expectations and yields – so that we can understand how any combination of fiscal and monetary policy is seen as translating into inflation outcomes and growth.
Secondly, the central bank could simply turn up at central government auctions and buy the bonds – this (depending on whether they hold the bonds to maturity, and whether it gets wiped off the governments balance sheet) is debt monetization.
Such actions come at the risk of unanchoring inflation expectations … but given the situation we are in fear of inflation isn’t necessarily an appropriate way of measuring the risks. Jordan Gali has talked about this clearly in his paper here, and his recent VoxEU post.
Money-financed fiscal interventions are a powerful tool. The caveats mentioned above suggest that policymakers should resort to them only in emergency situations, when other options are bound to be ineffective or trigger undesirable consequences, current or future (e.g. a debt crisis down the road). Unfortunately, that emergency is currently upon us, provoked by the coronavirus. If ever, the time for helicopter money is now.
This bears similarities to the discussion on central government and central bank coordination I had here. However, when thinking about this as a way to fund spending for COVID-19 I want to split matters in two:
- If we come out of the crisis with underutilised resources, then money financing offers a way of helping to boost demand at the zero lower bound – or save that, simply having the government increase borrowing while the central bank undertakes QE.
- If the debt is money financed during the pandemic it is less clear that this is appropriate – taking on debt which can be then paid back with targeted taxation later allows society to determine who pays. Increasing the stock of money when at capacity will arbitrarily crowd-out other scarce resource uses, and lead to arbitrary and potentially unfair sacrifices.
Keeping these ideas separate, and referring to the concept that is most appropriate to the time period at hand, will hopefully help us understand the reason for the variety of central bank actions over the next year!