The world economy is at a turning point. After almost 15 years of low inflation and near-zero short-term rates, we are in the midst of a new inflationary phase of and higher interest rates. No one knows how long this phase will last.
Author: Dr Philip Turner
Published: 24 October 2022
The world economy is at a turning point. After almost 15 years of low inflation and near-zero short-term rates, we are in the midst of a new inflationary phase of higher interest rates. No one knows how long this phase will last.
Central banks face this turning point from an extreme starting position. For more than a decade they bought long-term assets to lower core bond yields. Financial regulation reinforced the downward pressure on long-term interest rates. The regulators tolerated increased interest rate exposures in banks and, more dangerously, in non-bank financial intermediaries (NBFIs). These exposures in the financial system as a whole are leveraged, opaque and interconnected. They are global. UK pension funds are just “the first bodies to float to the surface.”
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One practical challenge for central banks is that these policies have widened the overlaps between monetary policy actions and the responsibilities of Treasuries, government debt managers and financial regulators. Current policy frameworks, with the emphasis on separate accountabilities, fall short of what is needed.
This note is about one dimension of this question: the connections between financial stability policy (that is, central bank emergency market intervention/lending operations and macro-prudential policies) and monetary policy.
Monetary policy, emergency intervention and macroprudential policy
Today a monetary policy question relevant to this issue (and one which does not get enough analysis) is: which tools should central banks use to bring about the desired degree of monetary tightening? Should they increase short-term rates or should they reduce their crisis-inflated balance sheets and increase long-term rates?
Also meriting reflection is the strategy behind emergency intervention – when the central bank has to curb the pro-cyclical impulses of financial markets in a crisis. There are many ways to do this. The central bank may buy assets for this purpose. Faced with a bond market crisis provoked by a fiscal policy blunder in September 2022, the Bank of England undertook to buy government bonds, if necessary on a large scale. It cited financial stability concerns apparently related to some pension funds’ leveraged positions in government bonds. But because buying bonds is also monetary expansion, the demarcation between two quite different policy objectives becomes blurred. One question is whether large and ever more frequent market interventions can be called “emergency”? What regulatory or monetary policy failures do such interventions betray?
The macroprudential question is: can the financial system (including non-bank financial intermediaries or NBFIs) cope smoothly with large shocks to interest rates, long and short? This question is closely related to the monetary policy question of how to reverse Quantitative Easing (QE) in an orderly way.
Public debate about these questions usually follows independent paths, with policies in most jurisdictions the direct responsibility of distinct entities. The Bank of England has two committees: the Monetary Policy Committee or MPC is responsible for monetary policy and the Financial Policy Committee or FPC is responsible for macroprudential/regulatory policies. Emergency market or lending operations are decided by the Bank’s management, in consultation with HM Treasury. But there appears to be no systematic deliberation at the MPC or the FPC (Allen (forthcoming)).
The rise of macroprudential policies has accentuated these interdependencies because, like monetary policy, they react to, and influence, macroeconomic developments. How to combine monetary and macroprudential policies is complex. On many occasions, tightening macroprudential policy is more effective when combined with an easing in monetary policy. So it cannot be assumed that these policies should necessarily pull in the same direction, which would simplify coordination.
The monetary/macroprudential links have been deepened over the past 15 years by two fundamental developments. One is the monetary policy revolution provoked by the Global Financial Crisis (GFC). The other is the greater reliance on market-based finance, notably via bond markets.
The monetary policy revolution
The monetary policy revolution is that the active use of the central bank’s balance sheet has opened up a whole new class of powerful and flexible policy instruments.
The “safest” avenue was QE, buying government bonds to lower long-term interest rates and increase bank reserves. Central bank purchases and sales of government bonds have long been advocated as an instrument of monetary policy. After the GFC, central banks went beyond “safe” assets by buying (or lending against) risk assets — mortgage-related bonds, corporate bonds, domestic equities and much else. The ECB allowed commercial banks to decide the size of the central bank’s balance sheet by offering them medium-term loans virtually on demand.
These radical measures aimed to counter impediments to the transmission of monetary policy intentions. But they came at the price of creating new overlaps with the mandates of other agencies – especially the Treasury and financial regulators.
The balance sheet will be a rich source of policy instruments for years. Huge holdings of long-term assets cannot be sold quickly. Nor can the medium-term funding of banks be halted overnight. Both politicians and the public now have higher expectations of what central banks can achieve by their balance sheet policies.
Before 2020, central banks indicated they planned only a rather slow and passive reduction in their balance sheets. The main tool for monetary tightening would be higher policy rates. Indeed, even in 2021 with yields below 1%, central banks continued to buy government bonds. The Fed continued to buy mortgage-backed bonds when there was no blockage in mortgage finance. Apparently healthy banks in the euro area exploited to the full very cheap (part at negative interest rates) medium-term finance under the TLTRO programme.
By 2022, however, the scale and persistence of the inflation threat had led several central banks to envisage more rapid balance sheet reduction. The debate on the choice between raising the policy rate and reducing the balance sheet must take account of the financial stability implications. Central banks also need to decide which assets to sell.
Market-based finance
The other fundamental shift is the growing pre-eminence of bond markets in financial intermediation. Over the past fifteen years, bond markets have provided an increasing share of international credit, overtaking bank loans. This was driven both by the regulation of banks and by monetary policy in the advanced economies.
Basel III forced banks to reduce leverage and hold more capital against credit risks. Once again, however, the negotiators of Basel III failed to agree on a capital charge for interest rate risk in the banking book. In addition, they decided to allow all long-term government bonds even very long-term ones to count as high-quality liquid assets. Historically, central banks had allowed banks to count only short-term government paper as a liquid asset. Banks in the major countries therefore increased their holdings of long-term government bonds.
Leverage and maturity mismatches in market-based finance were left largely unregulated. As with banks, however, regulatory reforms did induce insurance companies, pension funds and others to reduce credit exposures. But inducing them to buy more “safe” government bonds often exposed them to greater interest rate risk.
Monetary policy pushed strongly in the same direction. Central bank asset purchases helped lower benchmark yields in the main international currencies relative to expected short-term rates. For several years, term premia (which had been positive in the past as a “reward” for investors willing to hold bonds rather than rolling over short-term bills) were substantially negative. Investors were led to buy higher-risk bonds to maintain yield.
Policy-makers failed to fully understand the power of the joint effects of new bank regulations, prudential rules applying to institutional investors and central bank balance sheet expansion all pushing in the same direction. Nor how it might complicate eventual monetary tightening.
This banks-to-bonds shift has three consequences. The first is that it made the long-term interest rate (compared to the short-term or floating rates of bank loans) more important for monetary policy (e.g., via its impact on debtors). It also made it key for financial stability. Leveraged investors in wholesale financial markets post government bonds as collateral. Hence spikes in long-term rates reduce the value of their collateral, and can trigger margin calls and destabilising asset sales.
The second consequence of larger bond stocks is that creditors face increased market interest rate risk. Although inevitable after years of low long-term rates, increased leverage in the non-bank financial system magnified exposures. Investors could take larger positions, trading volume expanded and bond markets were made to appear more liquid. It became cheaper to hedge interest rate risk exposures, often encouraging even more leverage. As noted above, increased interest rate risk was the very risk that bank regulators had failed to address.
A 2018 report by a group of the major central banks under the chairmanship of Ulrich Bindseil of the ECB and Steven Kamin of the Fed found that banks were therefore especially vulnerable to a rise in inflation to the 3-4% range, which would lead to a rapid increase in both long and short rates. They noted that banks would at the same time suffer increased credit losses as borrowers faced higher refinancing costs. Some banks face additional losses on leveraged capital market exposures. Such difficult-to-quantify losses, not included in their estimates, could make some banks non-viable.
The third consequence was that liquidity in core money and bond markets became more fragile. Maturity mismatches and leverage in NBFIs increased. When financial firms have balance sheets that are less resilient to shocks, they tend to react more pro-cyclically. If forced to sell into (or suddenly hedge against) falling markets, these firms magnify price declines. In March 2020, and on several earlier occasions, severe and sudden market disturbances led central banks to buy assets in order to forestall a financial meltdown.
The Bindseil-Kamin report in 2018 was prescient. On the second page of the executive summary, it warned that a snapback of interest rates might trap insurance companies and pension funds in a liquidity squeeze “driven by losses on derivative positions – which would result in greater collateral demands.” This exactly describes the dynamics which would force the Bank of England in September 2018 to become yet again a “reluctant market-maker of last resort” (Hinge (2022)).
Regulation has long failed to address the vulnerabilities created by capital market structures and the risk exposures of NBFIs. As Vitor Constâncio has been arguing for years, this is the most dangerous gap in the macroprudential tool-kit. Constâncio (2022) noted the vulnerabilities of money market funds (“banks without capital”) and central clearing counterparties. He suggested four reforms: limit the use overnight repos as funding for longer maturities; limit to US Treasuries the exemption of repos from bankruptcy proceedings affecting counterparties; make rules on haircuts and on margining less pro-cyclical; and restrict the re-use of securities (“re-hypothecation”). Don Kohn (2022) proposed that the SEC align the liquidity offered to bond fund investors to the liquidity of the underlying securities.
In short, the vulnerabilities of market-based finance have been known for years. Practical remedies have been proposed. The Financial Stability Board (FSB) has this issue high on their agenda. Yet international agreement on what to do has proved elusive (Hinge (2021)).
Three implications for central banks
Central banks are now grappling with a new, and much more uncertain, interest rate environment. The scale and nature of recent global shocks make it harder to assess the equilibrium level of real short-term interest rates. On top of this, long-term rates had been depressed by central bank purchases and by the favourable regulatory treatment of government bonds. Sharp recent rises in long-term rates have already hit some financial firms hard.
The frequency of threatened financial meltdowns suggests that macroprudential and other regulatory policies have failed to make capital markets and NBFIs robust enough so that MMLR operations are truly exceptional events.
All this suggests that monetary policies, emergency market or lending operations and regulatory policies have become more closely tied together. These linkages have important policy implications for regulation, for monetary policy and for central bank governance. What were regarded as distinct policy dimensions have become harder to disentangle.
The first is that regulators need to be prepared for how monetary policy decisions will affect the firms they supervise. They need to react now to the rise in interest rate risk exposures of banks and other intermediaries. Barwell and Aikman (2022) rightly argue that, because inflation may force the Bank of England’s MPC to raise real policy rates above their equilibrium level, the FPC should ensure that banks and others are prepared for a “severe interest rate spike”. To this might be added the consequences of the recent jump in long-term rates. Term premia globally have turned positive. Further increases in UK government borrowing and the abandonment of a medium-term financial strategy could increase term premia in sterling markets more sharply than in dollar markets.
The second implication applies to monetary policy. Monetary policy-makers will have to decide the mix between balance sheet reduction (and higher long-term rates) and increased policy rates. Some argue that this choice does not matter. If debt markets were perfect, they say, and arbitrage not limited by capital constraints, then the long-term interest rate is just the average of future short-term rates. Yet the expectations theory of the interest rate has failed empirical tests. The evidence of the past decade surely confirms the importance both of global factors (end of the global saving glut?) and central bank bond purchases – and neither depends on the local policy rate.
Balance sheet reduction will have different implications for financial markets than a macroeconomic-equivalent rise in the policy rate. When interest rate expectations are not firmly anchored, differences in the financial stability implications of the alternative policy choices could be of vital importance.
Those who run banks and other financial intermediaries know the dangers they face come as much from an unexpected steepening in the yield curve as from well-announced increases in the policy rate. Central banks therefore need to provide some public guidance about both their underlying policy strategy and their metrics for assessing bond market mis-pricing. To provide such guidance, monetary policy committees should release dot plots for their members’ expectations not only of the policy rate but also of the two-year and the ten-year yields at least one year ahead. The variance of these plots is especially telling when expectations become more unsettled, and can help in the design of stress tests. In this way, central banks could help banks and others prepare for the interest rate adjustment which is under way, and so mitigate the financial stability risks.
The third implication, and perhaps the hardest to swallow, goes to heart of central bank governance. Monetary and macroprudential policies have become so interdependent, and the linkages so complex, that the separation of central bank decision-making into the MPC and the FPC may have outlived its usefulness.
This controversial subject, beyond the scope of this note, has been lucidly analysed by a former Bank of England official responsible for the Bank’s financial market operations. Bill Allen (forthcoming) traces a number of policy errors by central banks since the GFC to the failure of those making monetary policy to take adequate account of what the banks needed as they negotiated their way through the financial crisis. He notes that the MPC was excluded from the Bank of England’s crisis management. Similar failings apply to those responsible for regulatory policy. The FPC had not been asked to make proposals for the earlier design of MMLR operations. It was, however, directly involved in the Bank of England’s recent bond purchases.
Conclusion
Central banks, treasuries and financial regulators face a volatile interest rate environment which will not settle down quickly. Managing the legacy of a financial system that had become too complacent that interest rates would remain low will be hard. Those who take decisions on monetary policy and on macroprudential polices must look beyond their immediate mandates, and address together the many linkages.
Those setting monetary policy need to take account of how their choice between increasing policy rates and selling long-term assets is likely to affect the behaviour of financial firms, especially those with large interest rate risk exposures. They need to understand how regulation (or the lack of it) influences such behaviour. Those responsible for macroprudential policies seeking to make the financial system more resilient to higher and more uncertain interest rates need to understand the implications of specific monetary policy choices. Emergency market interventions by the central bank, inevitably decided in haste, also require greater scrutiny.
At present, policy-makers seem to be largely failing to look beyond their narrow mandates. This needs to change.
