The global pandemic is stretching conventional notions of monetary policy to the breaking point.
In country after country, central banks are creating vast oceans of new spending power to help calm markets and offset the pain of locked down economies.
The U.S. Federal Reserve, the Bank of England, the Bank of Japan, the European Central Bank – and, yes, the Bank of Canada, too – are pushing into areas they have never gone before, buying up a dizzying assortment of assets with newly created money.
In the eyes of skeptics, these aggressive monetary manoeuvres risk an outburst of inflation down the road. Others, however, see the wave of money printing as simply an acknowledgment that drastic action is necessary to contain the stresses created by an imploding global economy.
What is beyond doubt is that policy makers are going to lengths they never would have considered a few years ago – or, for that matter, even a few weeks ago.
Consider Andrew Bailey, the recently installed governor of the Bank of England. Earlier this month, he wrote a column in the Financial Times in which he swatted away suggestions the British central bank should permanently increase the country’s money supply, then use that new cash to buy up freshly issued government debt.
This tactic, known as monetary financing, can help countries run bigger deficits by making it easier for government treasuries to sell their bonds. However, monetary financing has always been taboo for most of the world’s major central banks because it can lead to runaway inflation. Venezuela and Zimbabwe demonstrate what can happen when central banks start printing money willy-nilly to indulge a government’s desire to spend.
In his early April column, Mr. Bailey suggested that any loss of central bank independence was dangerous. If a central bank indicated it was prepared to permanently goose the money supply to purchase government debt, its perceived kowtowing to the government’s need to raise money could lead to “an unsustainable central bank balance sheet” and “damage credibility on controlling inflation.”
Within a week, he was forced to walk back those sentiments. Yes, the Bank of England conceded, it would buy up a raft of British government debt after all, although only temporarily. Crucially, though, it would be the Treasury, not the Bank of England, that decides when – or if – these purchases will be reversed.
What about all of Mr. Bailey’s earlier reservations about monetary financing? They apparently disappeared in the face of the British government’s overwhelming need to peddle its debt.
Other central bankers can sympathize. They, too, are being forced by circumstances to do things their predecessors studiously avoided.
The Fed, for instance, responded to growing signs of economic distress in March by boldly declaring it was willing to buy unlimited amounts of U.S. government bonds. For the first time, the Fed said it was also willing to buy investment-grade corporate bonds, something it stopped short of doing during the 2008 financial crisis.
This month the Fed added a dizzying list of other firsts. The most notable is a US$2.3-trillion program that will pump money into less visible corners of the economy. That includes loans to small businesses as well as municipal bonds and high-yield or “junk” bonds issued by riskier companies.
The Fed is now the buyer of last resort for vast swaths of the U.S. debt market. Rather than lending only to stable, solvent borrowers, as central banks traditionally have, it is rushing to “backstop virtually any part of the domestic financial system in trouble,” as Oliver Jones of Capital Economics puts it.
The Bank of Canada isn’t venturing quite as far as the Fed, but it, too, is breaking new ground. It is buying large amounts of federal government bonds – at least $5-billion of them each week – to help sop up the imposing amounts of debt Ottawa is issuing to help fund its stimulus program.
Such bond-buying manoeuvres, known as quantitative easing or QE, are old hat for most central banks, but they are a new experience in Canada. Meanwhile, the bank has embarked on a slew of new initiatives that will see it gobble up provincial bonds and corporate debt as well.
So who is paying for this massive wave of purchases by the Fed, the Bank of Canada and others? For now, nobody. Central banks are simply crediting themselves with the funds they need. In a fiat money system, they can do so with a few key strokes.
This process of using the central bank’s power to magic money into existence strikes many people as profoundly wrong. There can be sound logic to it, though.
If everything goes according to plan, the transactions will be reversed down the road, when times are better and markets are functioning more smoothly. At that point, central banks will sell their newly acquired assets back to private buyers and the money they are now creating will return to the central bank, essentially erasing the original act of money creation.
At least, that is the theory. In practice, things don’t always go so smoothly.
The Bank of Japan began QE nearly 20 years ago. Many other central banks adopted their own versions during the financial crisis more than a decade ago. Most of these transactions have never been reversed. Rather than being temporary, most QE now looks permanent.
The Federal Reserve’s balance sheet shows how dramatic the impact has been. Before 2008, the Fed held less than US$1-trillion in assets. As it bought up wonky assets during the financial crisis, and declined to reverse the purchases, its balance sheet doubled to more than US$2-trillion.
That was just the start. Waves of QE propelled the Fed’s holdings to more than US$4-trillion by 2014. Since the start of the pandemic, the balance sheet has taken another huge leap upward, expanding by a couple of trillion dollars in a matter of weeks. It now tops US$6-trillion and is continuing to grow at warp speed.
People can disagree on whether this is cause for concern. As Mr. Bailey of the Bank of the England would once have told you, a central bank that permanently increases the money supply, then uses the proceeds to buy up debt, raises tough questions about whether it is truly committed to low inflation. All that new money has to go somewhere in the economy and it could eventually be reflected in higher prices.
On the other hand, the massive money creation by central banks in recent years has yet to result in runaway inflation or, for that matter, much inflation at all. Across the developed world, pricing pressures have remained stubbornly low for more than a decade.
In some eyes, the lack of inflation suggests governments have the capacity to spend far more aggressively, for example on issues such as climate change. Followers of modern monetary theory or MMT, once considered a fringe school of economics, argue governments should ignore deficits and happily create as much money as is necessary to support the economy, create jobs and achieve other objectives.
Only a few months ago, MMT seemed revolutionary. Now it simply looks like a description of what central banks are already doing.
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