Much is At Stake as Central Banks Move Beyond Traditional Policy Limits

Central bank profitability as well as credibility are both underappreciated parts of a federal response to a crisis, and this time is no different.

Read time: 5 minutes

In Brief:

• Previously held notions of the boundary between fiscal and monetary policy have been thrown out the window with the urgent need to respond to the pandemic’s economic shock.
• Although the finances of central banks have not traditionally attracted much attention, it makes sense to revisit this topic now that many central banks are operating far beyond traditional policy limits.
• Not everyone appreciates that a central bank’s accounting equity can be negative without any reason for alarm bells to ring.
• But bondholders should be wary of central bank losses that breach credibility in the eyes of markets.

With the need for extremely high government debt levels to help overcome the economic shock of the COVID-19 pandemic, we are experiencing globally a surge in coordination between governments and their central banks. In fact, previously held notions of the boundary between fiscal and monetary policy have been thrown out the window.  

There are a lot of academic names for what is happening now – fiscal dominance, fiscal theory of the price level (inflation rate), and debt monetization – with subtle distinctions among these terms. But the gist of central bank actions today is their coordinated policy with central governments to ensure more affordable government debt repayment and effective fiscal stimulus.

There are two major historical examples of such coordinated policies. First, during WWII the U.S. Federal Reserve (Fed) and the U.S. Treasury colluded to contain financing costs for the war. Second, during the 1960s the Bank of England used a plethora of tools now considered common: they attempted to target interest rates to contain government financing costs; they attempted to manage the composition of government debt to balance costs and also appeal to certain investor bases; and they used macroprudential  credit tightening, which effectively means tightening credit across a wide swath of the financial system.

The successes and failures of these central banks very much depended on their historical circumstances, with the Bank of England hemmed in by not only a pegged exchange rate but also an eventual oil crisis.

Central Bank Credibility
How this evolves in the current crisis will depend critically not only on the future choices made by central banks and governments but also on the credibility of those choices. Here are five hypothetical scenarios between “the treasury” (any central government fiscal authority) and a government’s central bank:

1. Monetization: In this case the treasury does not repay the bonds it owes to the central bank, leaving the central bank insolvent and requiring the printing of money, resulting in inflation. A government may also opt for continually issuing debt and rolling over old debt into ever-larger amounts, with the central bank trying to keep up with money supply – this is known as permanent monetary financing of debt.

2. Reduce debt through inflation: The treasury and central bank collude to boost inflation. Bondholders, seeing the inflation, do not want to hold government bonds, so the central bank as financial regulator engages in financial repression (or regulation) to force them to hold government bonds. This scenario is hard to pull off successfully since bondholders demand higher yields as inflation is realized and this exacerbates debt costs, leaving the treasury and central bank running just to stand still. Debt management policy can try to steer more debt issuance in the long end of the curve where inflation does the most erosion of debt, but it is difficult to force the extension of maturity on markets. Financial repression also has economic efficiency costs.

3. Rate ceilings (yield curve control): By pegging the rate of long-term interest rates, the central bank makes debt repayment cheaper. This results in either inflation or deflation (usually inflation), but the central bank no longer targets inflation. It also requires deep knowledge of which investor types purchase which parts of the yield curve, since the central bank is continually assessing demand for bonds at different maturities given controlled rates of interest. The issue of central bank profitability will also arise.

4. Treasury defaults on private bondholders: Why would this happen instead of defaulting on the central bank? It is a specific case of a non-federalized currency union like the eurozone. In the past decade, the European Central Bank purchased sovereign debt from banks in order to remove this risk from private sector balance sheets. In this case, the conduct and composition of quantitative easing becomes extremely important for sovereign debt.

5. Monetary and fiscal policy not on the same page: There are two different branches here.

• The central bank could stick to its inflation-fighting mantra, while the treasury can decide on continued fiscal expansion. In this case, efforts by the central bank to tighten end up exacerbating fiscal costs. This is a situation where fiscal policy dominates monetary policy.
• In the late 18^th century, the Bank of Amsterdam tried to accommodate a surge in wartime issuance but was left ultimately with huge losses – losses so large it precluded any timely return to solvency. The government largely refused to fully replace the central bank’s losses. This example is from a long-ago era, but it does show we shouldn’t assume governments will always be happy to refill central bank losses.

Central Bank Profitability
Central bank profitability is an underappreciated part of all of the above. Although the finances of central banks have not traditionally attracted much attention, it makes sense to revisit this topic now that many central banks are operating far beyond traditional policy limits. The good news is that a central bank’s accounting equity can be negative without any reason for alarm bells to ring.

Different accounting rules apply to central banks. Instead of realizing losses, central banks credit an account with losses and slowly make up the difference over time through other regular operations. In some cases the loss is covered by the central government, but we would expect in the future for the central bank to use its special accounting powers instead. It could be that in the future, treasuries are unwilling to tax citizens to make up central bank losses and then inflation and demand will increase alongside currency depreciation.

Figure 1 gives examples of central bank loss experiences from the 1990s. It is important to note that these are not major money center banks and thus government recapitalization could happen at a smaller scale relative to the global market. It does reflect that there are “quasi-fiscal” costs to certain central bank commitments.

Figure 1.  Central Bank Commitments Can Result in Losses
Selected central bank losses in the 1990s

Source: International Monetary Fund.

Importantly, there are two other features of central bank loss management: size and time. Both of these features are wrapped into the credibility of the central bank. Large central bank losses can impair central bank profitability for a long period of time and so markets might not believe any return to positive balances is fast enough or credible enough. The market may also expect faster depreciation and higher inflation in order to speed up the process.

In the United States, I believe we will see continued policy coordination on debt management between the Fed and the Treasury Borrowing Advisory Committee (TBAC), which consists of senior representatives of a number of buy-and sell-side institutions. I also think that after a period of more calm in terms of Treasury-market functioning, the Fed will wind down its purchases aimed at normalizing on-the-run / off-the-run Treasury spreads and embark on controlling the short end of the Treasury curve. This is somewhat already anticipated by markets with the five-year U.S. Treasury hitting an all-time low on 7 May 2020.

Bondholders can therefore expect low rates for a long time. But they should keep wary of central bank losses that breach credibility in the eyes of markets.

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. U.S. Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Income from Treasury securities is exempt from state and local taxes. Although Treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply.  Any capital gains realized may be subject to taxation.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

Fiscal dominance is a scenario whereby monetary policy is said to be driven by fiscal policy. It occurs when government can determine the stock of debt, the path of total expenditures, and taxation.^. Under these conditions, the government can influence the inflation rate and the future flow of monetary base by raising the permanent level of expenditures without at the same time raising taxes.

The fiscal theory of the price level (FTPL) describes fiscal and monetary policy rules where by the price level is determined by government debt and fiscal policy alone, with monetary policy playing at best an indirect role. This theory clashes with the monetarist view that states that money supply is the primary determinant of the price level and inflation.

Debt monetization is a two-step process whereby  the government issues government bonds to cover its spending and the central bank purchases the bonds from secondary markets and perpetually rolls it over, leaving the system with an increased supply of money.

Macroprudential policies are financial policies aimed at ensuring the stability of the financial system as a whole to prevent substantial disruptions in credit and other vital financial services necessary for stable economic growth. One example of a macroprudential credit policy was the higher capital charge applied after the 2008-09 financial crisis to Global Systemically Important Banks that were thought to pose more risk to the system than smaller banks. In contrast, microprudential supervision and regulation focus on the safety and soundness of individual financial institutions, not the financial system as whole.

 A pegged exchange rate, also known as a fixed exchange rate, is a type of exchange rate in which a currency's value is fixed against either the value of another country's currency or another measure of value, such as gold.

Financial repression comprises policies that result in savers earning returns below the rate of inflation in order to allow banks to provide cheap loans to companies and governments, reducing the burden of repayments. It can be particularly effective at liquidating government debt denominated in domestic currency. 

On-the-run Treasuries are the most recent Treasury released for a certain maturity. Off-the-run Treasuries are those that have been issued before and remain outstanding. The on-the-run bond or note is the most frequently traded Treasury security of its maturity. Because on-the-run issues are the most liquid, they typically trade at a slight premium and therefore yield a little less than their off-the-run counterparts. 

The yield spread or credit spread is the difference between the quoted rates of return on two different investments, usually of different credit qualities but similar maturities. It is often an indication of the risk premium for one investment product over another.

The Treasury Borrowing Advisory Committee (TBAC) is an advisory committee governed by federal statute that meets quarterly with the Treasury Department. The TBAC's membership is comprised of senior representatives from a variety of buy- and sell-side institutions, such as banks, broker-dealers, asset managers, hedge funds, and insurance companies. The TBAC presents their observations to the Treasury Department on the overall strength of the U.S. economy as well as providing recommendations on a variety of technical debt management issues. 

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

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