14 July 2020
Author: Gavyn Davies, Executive Chairman
Before the economic crash caused by the coronavirus pandemic in March, it had been widely assumed that central banks would be largely impotent in the face of a renewed recession.
With interest rates close to the zero lower bound in many advanced economies, there seemed little scope to respond to an economic slowdown, either by directly reducing policy rates or by using asset purchases to lower long-term risk-free rates.
The concerns about rates proved largely justified, but the central banks were still able to stem the crisis by expanding the scale, scope and riskiness of their balance sheet activities.
The vast array of measures taken by the US Federal Reserve and the European Central Bank since March have been instrumental in reversing much of the dangerous tightening in financial conditions that occurred earlier this year.
In its recent annual report, the Bank for International Settlements concluded — with apparent approval — that central banks have “deployed their full arsenal of tools, sometimes in unprecedented ways” and “have been able to cross a number of previous red lines to restore stability during this crisis”.
The most obvious innovation has been to speed up and expand their government bond purchases, indirectly financing a large part of the increase in budget deficits needed to address the crisis.
In only a few weeks, most of the major central banks have increased the size of their balance sheets by 7 to 16 per cent of gross domestic product, more than in the two years following the 2008 financial crisis.
Although dramatic, the economic impact of large-scale government bond purchases is questionable. Unlike in 2008-11, there is little or no scope for the Fed to reduce the premium investors receive for longer-term US treasuries, though the spreads among bonds issued by EU members have clearly shrunk.
Many governments could have engineered much the same result by financing their budget deficits with newly issued short-dated treasury bills. After all, the consolidated balance sheet of the public sector contains the central bank’s liabilities. Under this interpretation, the central banks may have facilitated a fiscal expansion that could have happened anyway.
Another instrument that central banks adopted in very large scale in this crisis has been the provision of lender-of-last-resort facilities to the banking sector. Most of these have been through open-market operations and discount window lending. As usual, the ECB has relied heavily on targeted refinancing operations to inject liquidity.
However, the Fed has gone much further than the ECB in developing new instruments to restore financial stability and promote credit flows, leveraging government money in the process. Some of these programmes fall into the category of serving as market-maker-of-last-resort, a type of intervention that barely existed before 2007.
MMLR activities occur when central banks address market illiquidity by directly buying a wide range of risky financial assets, or accepting them as collateral. That allows asset holders to obtain cash by lending these securities out, rather than having to dump them into the market.
Such interventions are designed to prevent self-reinforcing runs on specific financial products, including money market mutual funds, commercial paper, leveraged bond funds and asset backed securities.
In financial systems that depend on non-bank providers of credit, there is a strong case for using such MMLR interventions to prevent financial panics, which can result in permanent reductions in asset prices, credit and economic activity.
The Fed’s extremely aggressive government bond purchases in March were designed to prevent illiquidity in the treasury market causing a run on the world’s most important “safe” asset. It also falls into the category of MMLR and was a key moment in ending the financial crisis.
These asset purchases are different from those conducted under quantitative easing, because MMLR buying should in theory be reversed as soon as market liquidity is restored.
With Treasury guarantees protecting the first tranche of any losses, these programmes could theoretically unlock more than $4tn of loans from the central bank to private corporations and municipalities. The Main Street Lending Facility, designed to help with the “last mile” of the loan process for small and medium-sized enterprises, could reach $600bn.
Now that the Fed has entered this controversial territory, both after 2008 and in the current pandemic, it has greatly expanded the potential future role of central banks to influence markets via their balance-sheet operations, at least during emergencies.
For investors, “don’t fight the Fed” is taking on an entirely new meaning — even at the zero lower bound for interest rates.