by Wolf Richter, Wolf Street:
An enormously important new regime gets engraved into central-bank handbooks. The ECB and Bank of England are also on board.
It makes sense in this era of high inflation, QT, rising policy interest rates, and high financial fragility in the banking system, after years of money printing and interest rate repression.
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The new regime was already tested successfully by the Bank of England last fall: Tightening through rate hikes and QT while simultaneously providing liquidity to the financial sector for a brief period to douse a crisis.
Today, the Fed confirmed the new regime: It hiked by 25 basis points, bringing the top of the range to 5.0%, and QT continues as before, while it is also providing liquidity support to the banks.
Some people call this principle stepping on the brake with one foot (QT and rate hikes) while stepping on the gas with the other foot (“QE”).
But liquidity support of this type is not QE, and doesn’t have the effect of QE, Fed Chair Powell explained today at the post-meeting press conference.
It’s more like stepping on the brake with one foot while putting an arm around the baby to keep her from hitting the dashboard – that’s how I’ve been explaining it, to stick with the foot-on-the-brake analogy.
Powell on the new regime:
“Recent liquidity provision increased the size of our balance sheet. The intent and effects of it are very different from when we expand our balance sheet through purchases of longer-term securities,” he said.
“Large-scale purchases of long-term securities [QT] are really meant to alter the stance of policy by pushing up the price and down longer-term rates, which supports demand through channels we understand fairly well,” he said.
“The [current] balance sheet expansion is really temporary lending to banks to meet those special liquidity demands created by the recent tensions. It’s not intended to directly alter the stance of monetary policy,” he said.
“We do believe it’s working. It’s having its intended effect of bolstering confidence in the banking system and thereby forestalling what might otherwise have been an abrupt and outsized tightening in financial conditions. So that’s working,” he said.
“We think that our program of allowing our balance sheet to run off predictably and passively is [also] working,” he said.
Fighting inflation while keeping banks from toppling.
Powell split the fight against inflation and the liquidity turmoil at the banks into two separate issues, to be dealt with by using two different sets of tools.
- Tools to fight inflation: Interest rate policy and QT.
- Tools to provide liquidity to the banks: The “Discount Window” (short-term loans against collateral at 5% from now on) and the new Bank Term Funding Program (loans for up to one year against collateral at a fixed rate near to 5%)
But banking sector turmoil may help the fight against inflation.
As a result of the turmoil in the banking sector, “financial conditions” have tightened and may tighten further. Tightening of financial conditions is precisely what the Fed wants to accomplish, how monetary policy is transmitted to the economy and ultimately inflation, by making loans harder to get and more expensive, and by making businesses and consumers more reluctant to borrow, and therefore putting downward pressure on credit-financed demand from businesses and consumers, which would theoretically take off pressure from inflation.
“We’re focused on this potential credit tightening and what that can produce in the way of tighter credit conditions,” Powell said.
“When we think about the situation at the banks, we’re focused on our financial stability tools, in particular, our lending facilities: The discount window and also the new facility,” he said.
The new regime at the Bank of England and ECB.
The BoE put this regime into action last fall when it bought long-dated government bonds for a few weeks to end a death spiral triggered by pension funds when they tried to deal with margin calls. But with inflation raging at 10%, the BoE has to also tighten monetary policy. As soon as the turmoil settled down, it ended the purchase program, sold those bonds, and continued with QT and rate hikes.
