Central banks’ recent responses to market meltdowns have, at best, raised questions about what they should do in crises that can’t be solved with monetary policy. At worst they’ve brought accusations of doing a coup.
Specifically, when the Bank of England intervened last year to halt a disaster in the gilt market — where an underfunded government budget served as the spark for a tinderbox of pension leverage — the limited scope of its bond purchases led to complaints from officials and one of the most entertaining Photoshops Alphaville has published. But the BoE had previously been tightening policy by reducing the size of its bond portfolio, so officials argued they had limited room to act.
It looks like that gilt-market mess was a wake-up call for central bankers and academics.
On Friday, a pair of officials discussed how best to create a framework for governments to buy bonds in times of market instability, no matter whether the central bank is tightening or loosening monetary policy.
The BoE’s Andrew Hauser discussed the lessons from its recent intervention in a Friday speech at the University of Chicago, along with the Dallas Fed’s Lorie Logan (formerly the head of the Fed’s markets desk).
The officials highlighted the importance of preventing dysfunction in government-bond markets for central banks to achieve their broader economic goals. But that responsibility poses a messaging challenge: if limiting dysfunction requires bond purchases, a tool normally used for easing policy and stimulating the economy, how do investors know that the central bank isn’t simply trying to ease policy under the guise of financial stability?
Both Hauser and Logan suggested a few key ideas to address that problem. One is to use “backstop pricing”, or prices that would only be attractive in a severe breakdown of market functioning. Another was transparency and communication, to ensure investors know the purpose of any bond purchases isn’t economic stimulus. And Hauser suggested time limits and targeting for interventions: the BoE for example used a 13-day intervention that was targeted at the type of bonds held by LDI strategies.
A pair of researchers addressed similar strategies to steady bond markets earlier last week, in a report for the New York Fed.
Stanford University professor Darrell Duffie and the New York Fed’s Frank Keane also recommended that the central bank make an explicit promise to intervene in markets in moments of instability — whether through buying bonds directly, or by supporting a bond-buying scheme run by the Treasury department.
Duffie is famous (in Alphaville circles) for his work on Treasury market structure, and spoke at the University of Chicago event as well.
In the US, at least, the Fed’s standing repo facility has created a permanent way to provide short-term financing to bond dealers. But Duffie said such a mechanism may not be sufficient, given the size of the government-bond market and the limits to large banks’ willingness to make markets.
“Central banks normally don’t buy securities except for QE purposes. But sometimes they have to, like in March 2020, there were problems with financing that were cured by the Fed lending money against Treasuries,” Duffie told Alphaville. “Still the bond market was quite dysfunctional for weeks afterwards. The Fed [eventually] had to buy $1tn of Treasury securities. Sometimes the financing is not enough.”
The “friction” between the fiscal and monetary authorities — called out by the BoE’s Andrew Bailey — could be fixed by a piece of Duffie and Keane’s proposal, which is that government bond buybacks are supplemented or even possibly supplanted by fiscal buybacks, schemes in which the Treasury would buy bonds directly from banks and other investors.
Their proposal would not only offer some security, but also could make it cheaper for governments to borrow, if the guarantee was ultimately priced into government securities.
There are two areas of concern. The first is that if intervention were pegged on exact thresholds that were made public, the market could easily game the system forcing the central bank to buy bonds in non-crisis moments. Fortunately, our authors have thought of that and suggest the standards be mutable.
The suggestions of a central bank at the ready to intervene in markets may offend free-market fetishists. But the promise already exists, according to the academics, it’s just not explicit.
The full speeches from Logan and Hauser are worth a read. You can find them here and here.
Read the full article here