As the COVID-19 pandemic is slowing economies around the world, central banks are introducing different measures to stimulate the economy. In this article, Clive Corcoran, Director, Pagoda Management Limited, analyses the Federal Reserve’s recent announcement to “continue to purchase Treasury securities and agency mortgage-backed securities in the amounts needed”, and what it could mean for the markets.
A dramatic press release issued March 23, 2020 by the US central bank contains the following sentence:
The Federal Reserve will continue to purchase Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning and effective transmission of monetary policy to broader financial conditions.
Effectively, this means that the Fed is going “all-in” on quantitative easing (QE). It is unprecedented (for example, this commitment was not made by the Fed in 2008) and, given the contemporaneous gridlock in Washington D.C., many analysts are seeing it as a final desperate blast of monetary policy.
With no upper ceiling on the potential expansion of the Fed’s balance sheet, and with the fed funds rate effectively at zero, it is not hard to avoid the conclusion that the Fed is essentially out of ammunition with respect to the unfolding economic and financial meltdown resulting from the COVID-19 pandemic.
The rationale behind QE, which was undertaken by the Fed initially in 2009 – subsequently augmented in three separate QE programmes –, was the idea of extending the more routine support for money market liquidity conducted via Open Market Operations (OMO). Instead of relatively short-term funding provided to banks through orthodox OMO in the repo markets, QE provided much longer-term and unorthodox support to financial intermediaries with asset purchases where there was no definite time limit to the duration of the purchases. Given the open-ended commitment to markets given by the Fed on March 23rd, and the uncertainty as to the duration of the virus and its impact on the global economy, effectively the Fed has become the unconditional guarantor to the maturity transformation function of the commercial banking system.
Just how concerned should we be that the Fed has had to go all-in?
One way of assessing this risk is to examine the following radical scenario. Since the beginning of QE programmes, some have proposed that the debt that has been acquired by the Fed and other central banks through their asset purchase programmes should be “cancelled”. When the Fed steps into the market to buy, say, $300 billion of US Treasury bonds, and transfers them on to its balance sheet, then why can it not simply expunge these as liabilities on the public balance sheet? The holders of these government bonds will be fully compensated – at current market prices – for these assets as they move to the Fed’s balance sheet so there will be no “penalty” imposed on the private sector.
What would be the adverse consequences from this cancellation approach? Clearly, the central bank – in writing off the assets – is creating a distorted balance sheet since the liabilities would not have been “cancelled” i.e. the additional money in circulation that was used to buy the bonds. If the central bank was to eventually sell the bonds acquired, this would reverse the outflows adding to the money supply and thus preserve the integrity of the balance sheet since its liabilities would be reduced by the amounts received from the sale of the previously acquired bonds.
Ben Bernanke was clearly mindful of this potential risk when asked to explain the rationale for the first round of QE to the US congress in 2010. He made the following comments regarding the eventual re-purchase of the assets that the Fed began buying in 2009:
However, to help reduce the size of our balance sheet and the quantity of reserves, we are allowing agency debt and MBS to run off as they mature or are prepaid. The Federal Reserve is currently rolling over all maturing Treasury securities, but in the future it may choose not to do so in all cases. In the long run, the Federal Reserve anticipates that its balance sheet will shrink toward more historically normal levels and that most or all of its security holdings will be Treasury securities […] the Federal Reserve may also choose to sell securities in the future when the economic recovery is sufficiently advanced and the FOMC has determined that the associated financial tightening is warranted.
The Federal Reserve did embark on a shrinkage of its balance sheet in 2018.
During 2015-18 the assets on the Fed’s balance sheet reached about $4.5 trillion (in 2008 the assets stood at $800 billion). The amount had declined to about $3.8 trillion by September 2019. As can be seen in the chart below this has now gone dramatically into reverse – with a total back up to $4.7 trillion as of March 18, 2020.
Prior to the March 23rd decision the Fed had capped the future purchases at $750 billion, and with US GDP at approximately $20 trillion the ratio of central bank assets to GDP would have reached more than 25% when the ceiling to that facility had been fully enacted. But with the “all-in” decision it is entirely unclear how much higher this ratio will go.
By way of context, recent announcements from the European Central Bank (ECB) indicate that after full implementation of their new APP program, the ECB’s balance sheet will exceed €5.5 trillion which would be about 40% of the euro area GDP. It is also worth pointing out that the equivalent ratio for the Bank of Japan is more than 100%.
Perhaps the CB assets/GDP ratio itself is not that significant, but it is rather the market’s belief in whether these QE programmes will eventually come to an end, with an eventual return of the bonds purchased into global capital markets. Otherwise what restraint is there on the liabilities side of CB balance sheets? Expressed in the simplest terms, why not simply keep printing more and more money?
If unlimited QE becomes an entrenched idea, the parody of governments issuing bonds only to have them sucked up by their central banks would seem to amount to an interesting and not very opaque variation on the logic behind Ponzi schemes.
