Central banks may be forced to rethink and even undermine one of their prized emergency policy tools as popular resistance mounts against giant cash transfers to commercial banks while interest rates climb, recession deepens and Treasury coffers drain.
The stakes are high as it potentially affects the future use and effectiveness of extraordinary monetary policies such as bond-buying ‘quantitative easing’ (QE) and questions the wider political independence of central bank policymaking.
The European Central Bank, Bank of England and U.S. Federal Reserve are all – to differing degrees – now facing a backwash from years of policy-driven but lucrative balance sheet expansion. As they lift interest rates, that balance sheet burns a hole in their pockets – or more particularly the pockets of their governments long used to windfalls coming the other way.
It’s the flip side of more than a decade of bond-buying QE – introduced to overcome the limits of near-zero policy rates when deflation fears dominated and which offered banks trillions of dollars of interest-bearing reserves in exchange for the bonds.
With rates falling or near zero, central banks made money on that switch as they hoarded higher yielding bonds, paid next to nothing on commercial bank reserves and transferred the resulting accounting profit to governments for spending.
Now that they’re forced to raise interest rates sharply before significantly reducing those balance sheets, bloated further by pandemic-related support, a massive pay day for the banks is in store while remittances to Treasuries dry up and even reverse.
The optics of those payments to banks while taxpayers go on the hook may prove politically toxic.
“Paying billions to banks for holding the safest possible form of liquidity may trigger criticisms from the public,” Axa Group Chief Economist Gilles Moec wrote, adding that it could be seen as “undue support” when rising rates already lift banks’ net margins and when the public purse is pressured by serial shocks.
Britain has been battling this issue all year.
After channelling some 120 billion pounds in profit to the Treasury over 13 years, the Bank of England last month incurred its first loss for the public finance since it launched its QE programme in 2009 – a 156 million pound monthly loss from its bond portfolio versus interest paid on reserves.
That will surely climb as the BoE is expected to at least double its policy rate, the rate paid on bank reserves, by May. Paul Tucker, the BoE’s former deputy governor, called on the central bank this month to limit the rate it pays on those reserves, and estimated it could save about 40 billion pounds the government is now desperately seeking elsewhere for its Nov. 17 revised budget statement.
And after more than $100 billion of transfers to the Treasury last year alone, the Fed’s net income also turned negative in September and will continue that way for some time as reserve payments rise.
The ECB on Thursday may well reveal how it plans to run the gauntlet.
WAR AND PEACE
With a total of almost 5 trillion euros in excess reserves, the ECB is expected to address how its rising deposit rate allows commercial banks to use the central bank like an ATM, ’round tripping’ emergency funding facilities with rates now lower than those earned from simply depositing the cash back at the ECB.
ECB-watchers think a solution could be some form of ‘reverse tiering’ of the payment of reserves related to amounts taken in so-called Targeted Long-Term Refinancing Operations (TLTROs) – which make up about a quarter of the ECB balance sheet.
While that may well end up being the least worst option, it’s laced with multiple problems – not least the precedent of retrospectively altering the original terms and conditions of the TLTRO loans and potentially muddying their take-up and effectiveness if needed in a future downturn or another shock.
Unicredit economic adviser Erik Nielsen described that option as “a seriously troublesome road”.
Goldman Sachs rates strategist Simon Freycenet reckons adjustment of TLTRO terms in order to lift that funding rate closer to the ECB deposit rates was probably the “least complicated solution” – but it had “clear disadvantages with regards to future policy and legal risks.”
The cost of doing nothing is barely an option. Axa models show that ECB rates rising to an expected peak of 3% next year would involve an excess reserves shock that depresses the euro zone fiscal balance by 1% in one shot.
All of which underlines the direct fiscal effect of QE monetary policy that many feared would complicate full exit from QE when policy rates need to spike hard to cool inflation – threatening central banks’ independence and their mandate to solely focus on price stability as governments’ political and budget pressures demand otherwise.
Kenneth Rogoff, the International Monetary Fund’s former chief economist, this week restated his argument that the Fed should have considered negative interest rates rather than doubling down on a QE program that’s now politically more difficult to reverse.
“For all their complaints about inflation, one wonders how prepared voters are for yet another deep recession,” Rogoff wrote in Foreign Affairs. “The changes in the political and economic landscape have become so profound that it seems unlikely for the foreseeable future that the Fed will choose to bring inflation down to pre-pandemic levels and keep it there.”
For Nobel laureate Joseph Stiglitz, the political imperatives of the war triggered by Russia’s invasion of Ukraine – at least partly responsible for the surge in inflation and interest rates this year – should reasonably dominate narrower market objectives and override opposition to the use of windfall taxes, as they have done in all previous major wars.
“It is a mistake to think that the war can be won with a peacetime economy,” he wrote in a Project Syndicate blog. “No country has ever prevailed in a serious war by leaving markets alone.”