The central bank can use different ways to manipulate the money supply in an economy. This is known as monetary policy.
The first way would be to change the reserve requirement of banks. Reserve requirement of a bank refers to the amount of liquid cash a bank must hold against deposited cash. This is largely to avoid bank runs (large withdrawals from banks as people fear banks have run out of money). Lowering the reserve requirement leads to more money supply in the economy as banks can loan out more money. Increasing the reserve requirement leads to less money supply as banks loan out lesser money.
The second way would be to change short-term interest rates. The interest rate at which the central bank loans out money to banks is called the discount rate. By lowering this discount rate that banks pay on short-term loans from the central bank, the central bank is able to increase the money supply.
The third way is for the central banks to repurchase government securities (treasury bills/bonds) from bondholders or to sell government securities. These bondholders – investors/banks receive funds when the central banks purchase government securities from them. Investors store the funds in banks which the banks loan out or proceed onto spend the money elsewhere, thereby increasing the money supply and this is known as Open Market Operation.
The final way is quantitative easing (QE). It is when the central bank buys longer-term assets from banks such as home-loans and this is done by using made-up money aka printing money. This can lead to massive inflation. However, the inflation rates will not rise if banks hoard the money instead of loaning them out.
So, what has the US Federal Reserve done in the past few months to fight the economic impacts of COVID? Well they have used two tools known as the forward guidance and QE. Forward guidance consists of telling the public not only what the central bank intends to do, but what conditions will cause it to stay the course and what conditions will cause it to change its approach. As for now, the Fed has communicated that it is going to keep interest rates at the Zero Interest-Rate Policy (ZIRP) and continue with purchasing long-term securities. Furthermore, the Fed has also engaged in purchasing its own securities, Treasuries, bonds and equities and this is basically creating money out of nothing to cushion the economy from COVID impacts in the short term. By right the Fed is not allowed to buy debt that is not backed by the government. However, in emergencies it can do so as long as it is considered as secure purchases. To separate things, it sets up a special purpose program, and then lends into it where money from Treasury provides the needed security. The program then buys up bonds or makes loans to the private sector. The fact that the Treasury has provided the security means that the elected government aka Mr. Trump has agreed to this plan.
This is obviously detrimental to the society as it leads to extreme acceleration of debt accumulation. Euro Pacific Capital’s CEO Peter Schiff recently highlighted in Twitter that it took 210 years to run the US national debt up to 2 trillion dollars and the most recent 2 trillion dollars was added in just 2 months. The only reason why the Fed is able to do this is because of the unique position they are in where USD is the reserve currency of the world and these measures are what helped to save the market back in March without them collapsing completely despite the lockdown. But what this is going to cause is never seen before inflation rates as fiat currency flood the system.
While printing money to stimulate the economy is a viable option in saving the economy from collapsing completely, I have come across a blog where they discuss on how yield curve control might be a better option. It is what Japan has done the past few years. The Bank of Japan has kept the short-term Japan Government Bonds close to zero without any serious damage to the economy or financial system. The Fed has already made the case for yield curve caps for short and medium-term bonds and the longer the effects COVID lasts, the stronger the case to extend yield curve control to long-term bonds as well.
What is yield curve control (YCC)? To understand YCC, we first need to understand how government bonds work. Let’s say we buy a 10-year government bond from the government for 1000$ and the annual bond yield rate is 5%. We will be receiving 50$ for 10 years and at the end of the 10 years, when the bond matures, we get back our 1000$. But when people feel that the 50$ is not good enough and there are better opportunities out there, they can decide to sell the bond. If many people decide to sell these bonds, this will increase the supply of bonds in the market thereby decreasing the price of the bonds. So, a bond purchased for 1000$ could be sold for 900$ and this would cause the bond yield to rise to 5.6% as the government continues to pay 50$. Now that is cleared, time for YCC. YCC is the relationship between rates on bonds of varying durations. Higher yield is generally demanded for holding longer-term bonds, meaning that the curve is normally upward sloping and central banks manage monetary policy through short-term rates only. However, in YCC, the central bank sets a target yield for short/medium/long term government bonds. A central bank pursuing YCC will announce its target rates and maturities -- and that it will buy those securities in whatever amounts are necessary to keep the rates there. Furthermore, it will cap longer-term borrowing costs for the government which will bring down rates for consumers and businesses. This also helps communicate the message that short-term rates will be staying low.
The main reason this is better is because of the ZIRP and US’s April Savings rate. US has seen its highest savings rate in April 2020 at 33% despite the ZIRP being introduced back in March 2020. This means that a liquidity trap is forming or has already formed. A liquidity trap is when interest rates are low but savings rate are high which renders the monetary policy of ZIRP as ineffective. Consumers will expect interest rates to go up because it cannot remain at zero forever and thus would avoid purchasing bonds as bond prices and interest rates are inversely related. You may argue that bond yield is going up but ultimately bond prices are falling and hence they would refrain from purchasing these bonds due to future outlook. Thus, when the Fed engages in YCC, it shows that it is committed and will boost confidence in consumers.
However, there are downsides in engaging in YCC. The biggest risk is the Fed’s credibility. This policy requires the Fed to keep interest rates at a low over some time but this means that it risks inflation to take off and there will be no way of stopping it. Of course, the Fed can step right back in and raise interest rates to stop the inflation or let the inflation rise. Both are equally bad as in the first scenario, the Fed will be breaking its promise and in the second one, the Fed will be criticized for not holding onto its inflation objective.
After spending half a day on looking into this, it appears to me that the YCC might be the best tool for the Fed to support recovery from the COVID recession but that being said it is only if the Fed is able to implement this policy smoothly and in a credible manner...
This content is accurate and true to the best of the author’s knowledge and is not meant to substitute for formal and individualized advice from a qualified professional.