Thanks to unprecedented interventions by central banks and fiscal authorities, the pandemic-induced financial strains of March-April 2020 are now well behind us. Unfortunately, as a consequence of the official actions necessary to stabilize the financial system, market participants now count on government backstops to insure them against the fallout from future disturbances.

Naturally, central banks should be prepared to combat extreme shocks that threaten financial stability. However, to limit excessive reliance on central banks, we need to ensure that financial institutions can continue to operate smoothly on their own even in bad times. This means redesigning parts of the financial architecture. While market participants have a major role to play, it is authorities who need to address externalities—spillover effects—and to improve incentives for the private sector to maintain the liquidity of markets and access to short-term funding in times of moderate stress.

With the pandemic-induced disruptions still fresh in memory, this is the perfect time to identify deficiencies and implement reforms aimed at improving the resilience of the financial system. Fortunately, the June 2021 Report of the Hutchins Center-Chicago Booth Ta sk Force on Financial Stability (H-B) addresses all the key challenges, laying out a broad agenda for U.S. financial reform. In addition, we have the July 2021 G-3 0 R e port that provides detailed proposals for reforming the U.S. Treasury market.

In this post, we discuss these reform proposals, highlighting areas where we strongly agree and believe that implementation is urgent. In particular, we emphasize the benefits that would come from changes in the Treasury market (cash and repo), in the central counterparties (CCPs) that have become the most critical links in the global financial system, and in open-end mutual funds holding illiquid assets. We also highlight the governance proposals in the H-B Report. In our view, full implementation of the agendas set out in the these reports would make the U.S. financial system far safer than it is today….

Central Banks and Climate Policy

Avoiding a climate catastrophe requires an urgent global effort on the part of households, firms and governments to reduce our reliance on fossil fuels. Like many economists, we support a carbon tax. We also favor generous fiscal support for R&D to substitute for fossil fuels and remove carbon from the atmosphere.

What role should central banks play in this global effort? That is the prime focus of this post. We argue that central banks must preserve the independence needed for effective monetary policy. That implies only a modest role in addressing climate change.

Central banks are involved in both financial regulation and monetary policy. In each case, there are some things that central bankers can and should do to help counter the threat posed by climate change. As financial regulators, they should implement an improved disclosure regime and develop tools to ensure the financial system is resilient to climate risks.

In conducting monetary policy, central bankers should follow a simple, powerful principle: do not influence relative prices. To be sure, it is and should be standard practice to use interest rates to influence relative prices between consumption today and tomorrow. However, central banks ought not influence relative prices among contemporaneous activities. We will see that achieving this form of relative price neutrality may require central bankers to shift the composition of their assets and to alter the treatment of collateral in their lending operations….

The ECB's New Strategy: Codifying Existing Practice . . . plus

When the ECB began operation in 1999, many observers focused on its differences from the Federal Reserve. Yet, since the start, the ECB was much like the Fed. And, over the past two decades, the ECB and the Fed have learned a great deal from each other, furthering convergence.

Against this background, it is unsurprising that the broad monetary policy strategies in the United States and the euro area converged as well. On July 8, the ECB published the culmination of the strategy review that began in early 2020, the first since 2003. The implementation of the new strategy comes nearly one year after the Fed revised its longer-run goals in August 2020 (see our earlier posts here and here).

If past is prologue, observers will exaggerate the differences. Perhaps most obvious, unlike the Fed, the ECB’s strategic update did not introduce an averaging framework in which they would “make up” for past errors. Nevertheless, we suspect that it will be difficult to distinguish most Fed and ECB policy actions based on the modest differences in their strategic frameworks. For the most part, both revised strategies codify existing practice, as they permit extensive discretion in how they employ their growing set of policy tools.

In this post, we summarize the motivations for the ECB’s new strategy and describe three notable changes: target 2% inflation, symmetrically and unambiguously; integrate climate change into the framework; and outline a plan to introduce owner-occupied housing into the price index they target (the euro area harmonised index of consumer prices). While the new strategy can help the ECB achieve its price stability mandate, in our view the overall impact of the revisions is likely to be modest….

The QE Ratchet

When it comes to quantitative easing (QE), where you stand definitely depends on where you sit. That is among the conclusions of the important new report of the Economic Affairs Committee of the UK House of Lords.

The report provides an excellent survey of how it is that central banks now use their balance sheets. Its key conclusions are the following. First, central bankers should clearly communicate the rationale for their balance sheet actions, stating what they are doing and why. Second, policymakers should provide more detail on their estimates (and uncertainties) of the effectiveness of their various actions, especially QE. Third, they should be aware that the relationship between central bank balance sheet policy and government debt management policy poses a risk to independence. Finally, and most importantly, central bankers need an exit plan for how they will return to a long-run sustainable level for their balance sheet.

We discussed several of these points in prior posts. On communication, we argued that central bankers should be clear about their reaction function for both interest rate and balance sheet policies (see here). On the justification for policymakers’ actions, we emphasized the need for clear, simple explanations tied to policymakers’ objectives, distinguishing carefully between the intended purposes (such as monetary policy, lender/market maker of last resort, or emergency government finance; see here). And, on the relationship between QE and fiscal finance, we noted how the ballooning of the U.S. Treasury’s balance at the Fed in the early stages of the pandemic looked like monetary finance, putting independence at risk (see here).

In this post, we turn to the challenge that Lord King highlights in the opening quote: the need to ensure that central banks do not see bond purchases as a cure-all for every ill that befalls the economy and the financial system, causing their balance sheets repeatedly to ratchet upward….

Talking about Tapering

In May, we argued that the FOMC needed to communicate its contingency plans for what they would do should the recent inflation pickup prove more stubborn than its members expect. Such transparency makes it more likely that financial markets will respond to incoming data rather than to policymakers’ actions. By clearly laying out their reaction function, central bankers can avoid disruptions like market taper tantrums.

In June, the FOMC began to remove the self-imposed communication shackles designed to encourage “lower for longer” interest rate expectations and address inflation risks more openly. Indeed, as the above citation from Chairman Powell indicates, at their June meeting, policymakers began to lay the groundwork for scaling back their large-scale asset purchases (LSAPs).

In this post, we start by highlighting how recent Fed communication (which reveals appropriate humility about inflation projections) has helped avoid a market tantrum so far. Along the way, we discuss the various means that FOMC participants have used to express their changing views about the timing of interest rate increases (“liftoff”), even as they make clear that tapering their asset purchases will come first….

Central Bank Digital Currency: The Battle for the Soul of the Financial System

While the conflict is largely quiet and out of public view, we are in the midst of an epic battle for the soul of the financial system. Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable.

The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilization can lead to a very unstable global system that thwarts monetary control.

Central bank digital currency (CBDC) can take many forms. While some may be benign, the most radical version—one that is universally available, elastically supplied, and interest bearing—has the potential to trigger destabilizing financial shifts, weaken the supply of credit, and undermine privacy….

Understanding How Central Banks Use Their Balance Sheets: A Critical Categorization

This comment is jointly authored by Stephen G. Cecchetti and Sir Paul M.W. Tucker.

Central banks have been reinvented over the past decade, first in response to the financial crisis, and then as a consequence of Covid-19. While trying to maintain monetary stability and promote economic recovery, their balance sheets have ballooned. In 2007, the central banks in the United States, euro area, United Kingdom, and Japan had total assets from 6% to 20% of nominal GDP. By the end of 2020, the Fed’s balance sheet was 34% of GDP, the ECB’s 59%, the Bank of England’s 40%, and the Bank of Japan’s 127%.

Before it is possible to consider how well this worked, it is necessary to be clear about what policymakers’ various operations were trying to achieve. Headline declarations of aiming at “price stability” or “financial stability” are unsatisfactory as they jump to end goals without attending to the motivations for specific operations and facilities. The case of the Fed is illustrative. Among other things, they bought U.S. Treasury bonds, offered to purchase commercial paper, corporate and municipal bonds, and set up facilities to lend directly to real-economy businesses as well as to securities dealers. These cannot be assessed solely on whether, alone or together, each materially improved the outlook for economic activity and inflation.

Without a sense of the intended purpose of each central bank action, it is difficult for political overseers or interested members of the public to hold central banks accountable. Precisely because central banks are independent (rightly in our view), that accountability takes the form of public scrutiny and debate. But we argue that it is also hard for central bankers themselves to do their jobs unless they distinguish carefully—in internal deliberations, and external communication—the rationale for different interventions….

Climate Finance

Climate change is the topic of the day. The World Meteorological Organization tells us that the 2011-20 decade was the warmest on record. Earlier this year, the U.S. government re-joined the Paris Accord, and is proposing a range of new programs to mitigate the long-run impact of climate change. Now that a warming planet has made the Arctic increasingly navigable, national security specialists are concerned about geopolitical risks there. Thousands of economists have endorsed a carbon tax. Even central banks have joined together to form the Network for the Greening of the Financial System—a forum to discuss how to take account of climate change in assessing financial stability.

Against that background, last month, NYU Stern’s Volatility and Risk Institute (VRI) held a conference on finance and climate change. Speakers addressed issues ranging from the modeling and measurement of climate risk in finance to assessing its impact on the resilience of the financial system. In this post, we primarily focus on one of the central challenges facing policymakers and practitioners: what is the appropriate discount rate for evaluating the relative costs and benefits of investments in climate change mitigation that will not pay off for decades? We also comment briefly on several other issues in the rapidly growing field of climate finance research.

Past responses to the discount-rate question vary widely. Some observers call for a discount rate matching the high expected return on long-lived, risky assets—a number as high as 7%. This would imply a very low present value of benefits from investments to mitigate climate change, consistent with only modest current expenditures. Others postulate that climate change could lead to the extinction of humanity. For plausible discount rates, the specter of a nearly infinite loss means that virtually any level of mitigation investment is warranted (see, for example, Holt).

Recent climate finance research that we summarize here comes to the conclusion that over any reasonable horizon, the appropriate discount rate for computing the net present value of investments in climate change mitigation should be relatively low….

Inflation: Don't Worry, Be Prepared

Everyone seems to be worried about inflation (see here and here). People also are concerned that the rising media salience of inflation could raise inflation expectations, leading to a sustained rise in inflation itself.

April price readings certainly boosted these worries: the conventional measure of core inflation—the CPI excluding food and energy—rose by nearly 3% from a year ago, the biggest gain since 1995. Fed Vice Chair Richard Clarida summed up the nearly universal reaction when he said: “I was surprised. This number was well above what I and outside forecasters expected.”

The experience of the high-inflation 1970s makes people prone to worrying about such things. Our reaction is different. After all, worry alone is not going to prevent a sustained pickup of inflation. Only credible anti-inflationary monetary policy can do that. To ensure that inflation expectations remain low, it is up to the central bank to make sure everyone understands how policy will respond if the latest elevated inflation readings prove to be more than temporary. As we have written before, the key is effective communications, not premature action….

Optimal Settlement Speed

Over the past year, a series of events has shifted the attention of both experts and laypersons to the arcane processes that support trading and settlement in the U.S. securities markets. The massive volume of U.S. Treasury sales in March 2020 at the start of the COVID crisis boosted liquidity needs at precisely the time when resources were scarce, overwhelming the over-the-counter trading system and compelling unprecedented Fed interventions (see our earlier post). Similarly, the late-January 2021 episode involving extraordinary activity in GameStop, in large part through Robinhood (the broker-dealer), highlighted how a surge in equities trading volume can concentrate counterparty risk and trigger a jump in liquidity needs to settle those trades (see our earlier post). After filling the news for weeks, the equity market turmoil triggered Congressional hearings (see here and here).

In an effort to reduce both counterparty risk and liquidity needs, a number of observers are focusing on shortening the settlement period. Officials at the Depository Trust and Clearing Corporation (DTCC) are calling on the industry to halve the equities settlement period from two days (T+2) to one (T+1) by 2023. Others have called for far faster clearing, including nearly instant settlement (see here).

Times like these lead us to ask: how can we improve the efficiency and safety of the financial plumbing? We see plenty of room for progress in speeding settlement, thereby reducing both risk and liquidity needs during periods of stress. However, we also think that things can go too far (or too fast). In particular, we are deeply skeptical of calls for real-time settlement (T+0) for securities or foreign exchange transactions. In this post, we suggest why the optimal settlement period for some financial transactions is not zero….

Steve Cecchetti and Kim SchoenholtzMay 3, 2021

Commentary

Money, Banking, and Financial Markets