The malfunctioning of the government bond market in a developed economy is an early warning of potential financial instability. In the United Kingdom, the new government’s proposed “mini-budget” raised the specter of unsustainable sovereign debt and led to a dramatic widening in long-term gilt yields. Recognising the systemic importance of the government bond market, the Bank of England correctly stepped in, both pausing its plan to unload gilts from its balance sheet and announcing that it will buy gilts over a fortnight at a scale near that of its planned sales for the next 12 months.
Markets have since calmed down. But as commendable as the BOE’s prompt response has been, we must ask what blame central banks bear for financial markets’ current fragility. After all, while long-term gilt yields have stabilised, gilt market liquidity (judging by bid-ask spreads) has not improved. And across the Atlantic, the market for US Treasuries is also raising liquidity concerns. Many metrics are flashing red, just like at the onset of the COVID-19 pandemic in 2020 and in the aftermath of Lehman Brothers’ failure in 2008.
After two years of quantitative easing (QE) – when central banks buy long-term bonds from the private sector and issue liquid reserves in return – central banks around the world have begun to shrink their balance sheets, and liquidity seems to have vanished in the space of just a few months. Why has quantitative tightening (QT) produced that result? In a recent paper co-authored with Rahul Chauhan and Sascha Steffen (which we presented at the Federal Reserve Bank of Kansas City’s Jackson Hole conference in August), we show that QE may be quite difficult to reverse, because the financial sector has become dependent on easy liquidity.
This dependency arises in multiple ways. Commercial banks, which typically hold the reserves supplied by central banks during QE, finance their own asset purchases with short-term demand deposits that represent potent claims on their liquidity in tough times. Moreover, although advanced-economy central-bank reserves are the safest assets on the planet, they offer low returns, so commercial banks have created additional revenue streams by offering reserve-backed liquidity insurance to others. This generally takes the form of higher credit card limits for households, contingent credit lines to asset managers and non-financial corporations, and broker-dealer relationships that promise to help speculators meet margin calls (demands for additional cash collateral).
The speculators are not limited to hedge funds, as we recently learned in the UK. Rather, they also include normally staid pension funds that have engaged in so-called liability-driven investment: To compensate for the QE-induced low return on long-term gilts, they increased the risk profile of their other assets, taking on more leverage, and hedging any interest risk with derivatives. While their hedged position ensured that an interest-rate increase would have an equal impact on their asset and liability values, it also generated margin calls on their derivative positions. Lacking the cash to meet these calls, they were reliant on bankers with spare liquidity for support.
In sum, during periods of QE, the financial sector generates substantial potential claims on liquidity, effectively eating up much of the issued reserves. The quantity of spare liquidity is thus much smaller than that of issued reserves, which can become a big problem in the event of a shock, such as a government-induced scare.
Our study also finds that, in the case of the United States, QT makes conditions even tighter still, because the financial sector does not quickly shrink the claims that it has issued on liquidity, even as the central bank takes back reserves. This, too, makes the system vulnerable to shocks – an accident waiting to happen. During the last episode of QT in the US, even relatively small, unexpected increases in liquidity demand – such as a surge in the Treasury’s account at the Fed – caused massive dislocation in Treasury repo markets. That is exactly what happened in September 2019, prompting the Fed to resume its liquidity injections.
The onset of the pandemic in March 2020 was an even larger liquidity shock, with corporations drawing down credit lines from banks and speculators seeking help in meeting margin calls. Central banks duly flooded the system with reserves. One can only imagine the scale of the intervention that would have been needed if the shock had been as bad as the one in 2008. An even deeper crisis would have prompted some depositors to dash for cash, causing some banks to hoard spare liquidity to meet unexpected claims on the deposits they had amassed during the boom times.
Put differently, the larger the scale and the longer the duration of QE, the greater the liquidity that financial markets become accustomed to, and the longer it will take for central banks to normalise their balance sheets. But since financial, real, and fiscal shocks do not respect central banks’ timetables, they often will force fresh central-bank interventions, as we saw in the UK.
Monetary policymakers thus find themselves in a very difficult position. A central bank may need to raise rates to reduce inflation. But if it also must simultaneously supply liquidity to stabilise government bond markets, it risks sending a mixed message about its policy stance – not to mention raising concerns that it has become a direct financier of the government. Not only does this complicate policy communication; it also could prolong the fight against inflation.
While central banks have always had a duty to provide emergency liquidity, doing so on a sustained, large-scale basis is an entirely different kettle of fish. Our findings suggest that QE will be quite difficult to reverse, not least because QT itself increases the system’s vulnerability to shocks. While the BOE deserves praise for riding to the rescue, central banks more generally need to reflect on their own role in making the system so vulnerable.
Raghuram G. Rajan, former governor of the Reserve Bank of India, is Professor of Finance at the University of Chicago Booth School of Business; Viral Acharya is Professor of Economics at New York University’s Stern School of Business