When Professor Rajan was running the Reserve Bank of India he stood head-and-shouders above most all of the other Central Bankers of his cohort (except maybe for the RBI currency switcheroo of November 2016. That was a fustercluck)
From Project Syndicate, October 7:
Raghuram Rajan and
After two years of quantitative easing, central banks have begun to shrink their balance sheets, and liquidity seems to have vanished in the space of just a few months – revealing acute financial-system vulnerabilities. It is now clear that monetary-policy normalization will be exceedingly difficult and fraught with risk.
CHICAGO/NEW YORK – 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. Recognizing 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 stabilized, 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...
....MUCH MORE
Also at Project Syndicate:
Some of our posts on Professor (U.Chicago/Booth) Rajan:
February 11, 2022
Former Reserve Bank of India Head, Raghuram Rajan: "Central Banks Have to Start to Move"
Long time readers may remember Professor Rajan from such hits as:Raghuram Rajan on The Boom and Bust in Farm Land Prices in the United States in the 1920s
and:
India’s Central Bank Governor Discusses Robber-Baron Capitalism and a Fine Veg CutletOkay, I'm being a bit whimsical, the man is brilliant and I wish he was running the U.S. Fed rather than sitting in his comfy endowed chair at the Booth School of Business.
From Neue Zürcher Zeitung's TheMarket.ch, February 10:....
Also:
- Raghuram Rajan: "When the Interests of Monopolists and Authoritarians Coalesce"
- Raghuram Rajan: "Disruption, Concentration, and the New Economy"
- "World Out Of Whack: An Absurd Unintended Consequence Of Abnormally Low Rates"
- Fannie and Freddie Must Die! Some guy in Chicago Takes on Paul Krugman's Version of the Mortgage Mess (FNM; FRE)
And previously on our obsession with the events of September 2019:
"Economist Michael Hudson Says the Fed 'Broke the Law' with its Repo Loans to Wall Street Trading Houses"
A Nomura Document May Shed Light on the Repo Blowup and Fed Bailout of the Gang of Six in 2019
"A Closer Look at the U.S. Bacon Situation"
Money, Money, Money: "A Self-Fulfilling Prophecy: Systemic Collapse and Pandemic Simulation"
"The Federal Reserve's Explanation Of What Happened In The Money Markets In September 2019
What seems to have happened was that somebody's derivative book got upside down to the tune of a few trillion dollars (notional, always say notional) and in addition the contagion through the counterparty daisy chain was also in the trillions and well, here's the Fed with their version.
From the Board of Governors of the Federal Reserve System....
....And more to come. We've been picking at this scab for quite a while and the picture puzzle is only now coming together so dribs and drabs.
And how does this ancient history tie into what's going on in 2022?
I have a feeling that lands somewhere in "the nebulous region between mere suspicion and probable cause"(LaFave & Israel on U.S. v. Ramsey, 431 U.S. 606 [1977])that there is some sort of misdirection going on that I'm not understanding.If so, any attempt at analysis of Fed policy and market moves by traditional means, global macro, central bank policy and practice, market internals such as options gamma etc., etc. is just so much blather.And I keep coming back to the 3rd and 4th quarters of 2019 as the period when things were getting very weird.More to come (maybe)
Trouble In Repo Land—The QE Endgame: A Big Problem Is Emerging For The Fed
Also "The Fed Is About to Ramp Up Balance-Sheet Shrinkage. It May Get Dicey".
