One works, the other doesn’t

Central banks typically alter monetary policy through the price of credit (interest rates) and the provision of credit (usually lending to banks against collateral). Central banks can also alter the duration and credit risk of their lending, in the same way that QE can be used to alter the price of credit at varying durations in different segments of securities markets. In essence, central banks can affect, either directly or indirectly, the quantity, price, and duration of available credit and money in the economy. No central bank has come close to exhausting these powers. Excessive focus and reliance on changes in the policy rate – the overnight rate of ‘risk-free’ interest – and quantitative easing – the purchase of assets – has obscured the true power of central banks.

The multiple channels available to central banks are very clearly delineated in the ECB’s current mix of policies. The official policy rate influences the price of credit through interest rates in the money market, and interest rate expectations in the price of government bonds across the yield curve. The ECB’s QE programme involves the purchase of government and corporate bonds – an attempt to influence the availability and price of credit in different sectors and at different durations. Finally, the TLTRO programme is the direct provision of credit, to banks, targeted at investment in the real economy.

Helicopter money can be thought of as a logical extension along these axes: perpetual loans, at zero interest rates, to households. As Friedman made clear in the much more relevant AER presidential address in 1968, monetary policy is never impotent.[1]

Fortunately the only radical policy makers who seem to understand this are in fact at the ECB. They appear ahead of most economists, lost in confused pedantry, and politicians stuck in the 1990s. And they are already, pretty much unnoticed, opening up sets of policies that make helicopter drops look relatively tame.

The first key point is that there are two important interest rates, and they now may well have opposite effects on the economy. The one that gets all the attention, is the official policy rate. Reductions in policy rates to extremely low or negative levels appear to be dysfunctional – perhaps even a tightening of monetary policy. I will not rehearse the straightforward arguments as to why, and the early evidence. Suffice it to say that the most significant event in financial markets this year was the response of asset prices to the surprise cut in Japanese policy rates in January – the currency strengthened, risk assets fell. That looks like a tightening.

The ECB understands this. That is why it turned its focus to the other interest rate – the rate at which it lends to banks under its latest TLTRO programme. Disguised behind horrible acronyms, TLTROs are far more radical than QE, OMT, or SMP programmes. TLTROs are also so obviously legal that the German media barely bothers to mention them.

Here’s why TLTROs are hyper-radical – and will work. What are Targeted Long-term Refinancing Operations? They are loans which the ECB makes to banks at a duration and interest rate of its choosing, for specified purposes. With every TLTRO the ECB chooses the interest rate, the duration of the loan, and potentially, the credit risk. Why is this potentially more important than all other monetary tools? Because the ECB is never out of ammunition with a TLTRO. Just cut the interest rate further, extend the duration, and extend the scope of the lending. For example, the ECB could make 20-year TLTROs at -5% interest rates, available for durable goods purchases, in an amount up to 10% of GDP. Would it work? Just watch the share prices of automakers!

It should be obvious that this is totally different to setting official policy rates at ever-lower negative levels – at best a negligible stimulus, at worst an outright tightening of policy. When official policy rates are reduced, banks are being taxed – the value of their reserves declines now, and prospectively. At high levels of interest rates, where the demand for credit is being constrained, reductions boost consumer demand. But when rates are already so low that the price of credit is not the constraint, the principal effect is on the profitability of the banking sector, the pricing of bonds, and an income effect on savings. (The Bank of Japan acknowledged the latter effect by introducing tiered reserves – effectively a compensating transfer to banks).

So, there are two interest rates – the official policy rate, which should not be cut, and should probably be set at a small positive number; and the rate at which the central bank lends to the private sector, through the banking system – which should be cut as far as is necessary. The ECB has already set its course, ‘helicopters’ are merely a logical extension.

[1]There are two distinct policies: the old monetisation of fiscal policy, and transfers to the private sector financed by base money, under the control of inflation-targetting central banks. The latter began with paying interest on reserves, and making subsidised loans to banks. Tiered reserves are an extension, as are TLTROs. The issue of ‘permanence’ is a total distraction.

About The Author

Eric Lonergan is a macro fund manager, economist, and writer. His most recent book is Money (2nd ed) published by Routledge. He is also a supporter of Big Issue Invest (BII), the investment arm of The Big Issue, and is one of the initial limited partners in BII’s Social Enterprise Investment Fund LP. In a personal capacity, he makes direct investments in social enterprises. He also supports and advises The Empathy Museum.

8 Responses

  1. JKH

    Haven’t researched the TLTRO program, but my guess is that term financing is being offered on terms that result in relatively attractive locked in term spreads. The relative certainty and duration of the spreads matters. This increases bank lending motivation compared to the case otherwise of stumbling on fixed rate lending opportunities that then require a search for matched duration financing in a funding market that may not be operating that efficiently at low rates. I think a second major point is the issue of bank interest rate risk on variable rate lending. Lenders don’t want the uncertainty of wondering when policy rates will ever increase again (which would probably help spreads) or even fearing a further decrease in policy rates. In addition, the starting spreads for variable rate lending are almost certainly worse that the case of TLTRO.

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  2. Denys

    Yes, CBs have realized that the official interest rate is a blunt instrument. For instance, in the UK, if housing overheats the BoE (via regulation) reduces the allowed loan to value of new mortgages, whereas before it might have raised the interest rate.

    As for TLTRO or TFS in the UK, the central bank can lend at any rate that it likes. But 1) if it lent too much and too broadly it would in fact affect the market interest rates, indeed becoming the official rate in the limit. And 2) any loss that the ECB/BoE makes on subsidized lending reduces the profit that the Bank sends to the Government (or the government sends to the Bank in the extreme case) and is therefore a fiscal matter. Note that in the UK the BoE asks for a letter from the government concurring with TFS lending.

    I think the problem in discussing helicopter money is the confusion about the word “give” (eg the ECB gives money to the banks under the TLTRO scheme). If give means give, it is a fiscal matter. If give means lend then it’s not helicopter money. As for a zero coupon perpetual, with a wink and a nod that it doesn’t have to be repaid, these types of arrangements are quite common amongst corporate executives at companies such as Enron (is it on the balance sheet or not, etc etc, write on thing in a contract and actually mean another). Accountants book such things as equity (or gifts) and I suspect that the IMF would do the same when compiling its country statistics.

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    • Eric Lonergan

      Not sure it does affect the official rate even in extremis – because that is always determined by the IOR – but it might aftect market interest rates …

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  3. Lecturas para comenzar el Lunes 8 de agosto de 2016

    […] Los créditos del BCE que nos sacarán de la crisis Los Targeted Long-term Refinancing Operations son crédidos que hace el BCE por una duración y tiempo que él mismo elige y solo para fines específicos. Con cada TLRO el BCE elige el tipo de interés, la duración del crédito y, al menos potencialmente, su riesgo. Por ejemplo, el BCE podría hacer TLROs al -5%, para compra de bienes de consumo duradero hasta un límite del 10% del PIB. ¿Funciona? Basta con mirar la evolución en bolsa de las empresas de automoción y autopartes. […]

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