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Quite erroneous policy

by Charles Goodhart, Geoffrey Wood

Quite erroneous policy

At a time when interest rates, throughout the yield curve, are at an all-time low, it could be argued that the public sector, the biggest debtor, should be trying to lock in such rates by shifting to ever longer maturities and duration.

However, if one adjusts for central bank swaps, under which central banks effectively buy longer-dated government debt in exchange for sight deposits, the overall maturity of public sector debt in most countries practising quantitative easing has been going down, not up.

We are told that such central bank deposits need not, indeed should not, ever get repaid. That they are, or should be, the equivalent of Consols (a type of British government bond redeemable at the option of the government) – quasi-permanent debt.

Jeremy C. Stein, professor of economics at Harvard University, argues that satisfying liquidity needs enhances financial stability and that monetary policy can continue by varying the interest paid on central bank deposits.

He adds that enlarged central bank balance sheets should remain a permanent feature. But as such reserve deposits are now interest-bearing, the huge volume of central bank deposits increases the public sector interest rate roll-over risk just as much as if the Treasury had issued a similar amount of Treasury bills.

If liquidity needs are satiated in this way – at a time when debt ratios have been climbing at a rate hitherto unparalleled in peacetime – why are there still claims that interest rates are being held down by excessive demand for ‘safe’ assets? Is this claim consistent with the narrowed risk premia now being observed?

Charles Goodhart Chart

Furthermore, if the demand for liquidity, and reserves, by banks is to remain satisfied, what then constrains, and determines, the aggregate money stock, mostly consisting of commercial bank deposits, and bank lending to the private sector? The answer, we would presume, is the availability of bank (equity) capital. But capital will be made available only if the business is sufficiently profitable to earn a competitive return (unless the public sector injects the capital itself).

In the banking sector, negative interest rates, a flat yield curve, and substantial fines on the banking institutions (rather than the bankers who perpetrated, or failed to prevent, the misdeeds) are not conducive to greater profitability. Profitability is procyclical.

Has policy been actively damaging bank profitability and hence growth of money and credit? In most academic studies of the efficacy of monetary policy, all that appears to matter is the direct link between riskless official short-term rates, and future expectations thereof, and the real economy.

In David Reifschneider’s 2016 Federal Reserve Board paper, ‘Gauging the ability of the FOMC to respond to future recessions’, the words ‘bank’, ‘money supply’ and ‘credit’ do not appear. The same official insouciance about the profitability of financial intermediation goes wider than just banks. Insurance companies and pension funds are pressured to hold matching assets against their liabilities. Policy then serves to reduce the availability and yield of such assets.

If the effect of monetary policy has been to weaken the profitability of financial intermediation, might this help to explain why the massive monetary expansion measures undertaken by central banks have had so little impact on the real economy? Perhaps QE has now become ‘Quite Erroneous’.

Charles Goodhart is Professor Emeritus at the London School of Economics and Political Science. Geoffrey Wood is Professor Emeritus of Economics at the Cass Business School.