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How BoE policy confusion played part in gilt meltdown - an important categorization of CB toolkit

Updated: Sep 25, 2023

Since 2010, the central bank balance sheets have expanded considerably. The conventional objectives of price and financial stability are insufficient to assess the efficacy of contemporary central bank operations. We require a whole new paradigm for categorizing and interpreting central bank balance sheet activities. The provisions for lenders of last resort, market makers of last resort, selective credit provision, and emergency government financing needs to be kept separate from decisions about monetary policy. To maintain legitimacy and accountability, central banks should explicitly segregate these operations by specifying their aims, objectives, and constraints.

The past decade has witnessed the reinvention of central banks, first in response to the financial crisis and later as a result of Covid-19. Their balance sheets have exploded to maintain monetary stability and foster economic recovery. In 2007, the total assets of the central banks of the United States, the euro area, United Kingdom, and Japan ranged from 6% to 20% of nominal GDP. By the end of 2020, the Fed's balance sheet represented 34% of GDP, the ECB's balance sheet represented 59%, the Bank of England's balance sheet represented 40%, and the Bank of Japan's balance sheet represented 127% of its GDP.

Before evaluating the success of this strategy, it is crucial to understand the objectives of the various policymakers' actions. Headline assertions of 'price stability or 'financial stability' are unsatisfying since they skip over the rationale behind particular operations and facilities. The Fed serves as an illustration. They purchased US Treasury bonds, offered to purchase commercial paper, corporate and municipal bonds, and established facilities to lend directly to real economy enterprises and securities dealers. These cannot be evaluated purely based on whether each significantly boosted the economic activity and inflation forecast, individually or collectively.

It is difficult for government overseers and concerned public members to hold central banks accountable without clearly understanding each action's intended objective. Because central banks are independent (as we believe they should be), accountability takes the form of public inspection and discussion. However, we contend that it is also tricky for central bankers to accomplish their duties if they do not identify carefully – in internal meetings and external communication – the reasoning for such actions.

After reserve requirements were eliminated in the early 1990s, central bankers utilized only two instruments for many years: open market operations and discount-window lending facilities to promote financial system stability. This altered as of mid-2007 due to two characteristics of contemporary finance. First, non-bank financial intermediaries — money funds, finance firms, structured finance vehicles, broker-dealers, and the like, which account for approximately 30 percent of private finance in industrialized economies – might deplete their liquidity in ways that wreak havoc on the actual economy. Moreover, financial markets may freeze up if even reputable dealers stop making markets. As a result, central banks were forced to respond to runs on non-bank intermediaries and vital financial markets. Then, when Covid-19 struck and governments suddenly needed cash to support individuals and businesses, central banks stepped in again. They also supplanted broken, frozen, or sclerotic private markets and modified loan facilities to target specific industries and regions.

This is not the world depicted in textbooks, in which central banks provide a flexible currency and serve as a lender of last resort to solvent banks à la 19th century. Therefore, communities require a new vocabulary for discussing what central banks do and why they do it. Only then can it be determined whether words and actions align and whether revisions are necessary.

Classifying balance sheet operations and facilities of central banks

We formally categorize the central bank action in the following five categories as it offers clearer communication based on policy objectives and purposes:

Monetary policy: boosting or stifling aggregate demand to achieve price stability while maximizing the use of the economy's productive resources.

Lender of last resort: lending funds to fundamentally solvent enterprises or other collective vehicles with liquidity requirements that cannot be addressed through private markets

Market maker of last resort: addressing specific market liquidity issues

Selective credit support: directing loans to particular industries, regions, or businesses

Emergency government financing: supplying the necessary finances straight to the government.

Monetary policy

The majority of individuals equate central banks with monetary policy. Central bankers utilize their balance sheets to decide the amount or cost of their currency to accomplish price stability objectives. When policy rates approached their effective lower bound in recent years, the central bank's primary instrument shifted from prices (overnight interest rates) to quantities. To increase aggregate activity and inflation, the government seeks to cut long-term interest rates and compress different risk premia by purchasing securities. The efficacy of quantitative easing (QE) is debatable. Nonetheless, regardless of what we or anybody else thinks of its effectiveness, bond purchases of this type fit neatly into conventional notions of monetary policy.

Quantitative easing is not necessarily meant to promote aggregate spending directly. Bonds may be purchased to maintain a market's liquidity, finance (private or public) issuers, or provide capital to investors and traders. Therefore, it is vital to distinguish between the various balance-sheet activities.

Lender of last resort

Lender of last resort (LOLR) is willing to fund solvent but illiquid firms. This is a form of liquidity re-insurance for financial intermediaries that provide liquidity services for the entire economy. Because the central bank has an endless capacity to print money (as long as its liabilities continue to be regarded as money), it is the only body that can assume this position on short notice; a treasury would have to raise funds, maybe by borrowing from the central bank. The essential question is which types of businesses and under what circumstances should access these services. When banks dominated the monetary and financial system, the lender of last resort services was tailored to their needs.

Broker dealers, money market funds, and other intermediaries already participate in bank-like operations by offering demandable liabilities backed by assets with less than complete liquidity and no direct access to the central bank. However, recent research indicates that they will receive aid when in peril. This category includes, for example, the Federal Reserve's liquidity support initiatives for primary dealers and money market mutual funds.

A trustworthy, honest, and explicit framework is preferable to a series of improvisations. If non-banks have access, there must be an open-standing facility subject to regulatory constraints. If not, structural measures must be taken to ensure that non-banks never need to borrow from the central bank and that investors do not perceive their liabilities as secure.

Market maker of last resort

The purpose of market maker of last resort (MMLR) actions is to restore liquidity in a market deemed (directly or indirectly) crucial to the real economy. When interest rates are zero, market maker of last resort activities to maintain liquidity on government bond markets may resemble quantitative easing, but they are not. Such interventions are conceivable at any level of the policy rate. Similar to the lender of last resort, a well-designed market maker of last resort must have a large capacity yet may only be required to fulfill minimal tasks. In addition, any purchases made by the market maker must be reversed once the target market resumes normal operations. MMLR is neither an investment nor a facility for term finance. When the market maker of last resort acquisitions is not unwound, the assets must serve another function, requiring additional rationale.

Numerous instances of MMLR operations exist. The paradigmatic illustration is Mario Draghi's "whatever it takes" program, in which the ECB promised a guarantee for eurozone sovereigns but ultimately purchased nothing. Bank of England's operations in sterling corporate bonds in 2009 also purchased a minimal number of corporate bonds. The Federal Reserve's Secondary Market Corporate Credit Facilities is the third instance. Immediate reductions in risk spreads and bid-ask spreads followed the March 23, 2020, announcement and subsequent two-week expansion (Gilchrist et al., 2020). The Fed's corporate bond and exchange-traded fund (ETF) holdings peaked at $14 billion – and may have been less than that.

Selective credit support

Next is selective credit assistance, which directs the allocation of economic resources by subsidizing lending to chosen borrowers. Policymakers may act in this manner for various reasons, many of which may have a political objective and imply political pressure. There is a need for a transparent system obliging purportedly autonomous central banks to declare what they are doing and why.

There are numerous examples of central banks steering loans to specific industries, regions, or businesses. Only three cases are mentioned here. Three longer-term refinancing operations are scheduled by the Eurosystem (TLTROs). While complex, euro area national central banks provide funding at favorable rates (as low as -1%) so long as banks pass it through as loans to businesses or non-mortgage home lending. The Fed's many credit-providing initiatives for local governments and small companies are a further example. PBoC also provides targeted credit facilities to Chinese SMEs and agricultural industries. In all cases, the central bank directs credit through implicit and explicit subsidies. These are fiscal operations, and we believe they should be treated as such. The government and central bank construct a transparently cooperative Funding for Lending program in the United Kingdom, elaborating on its budgetary component and aim.

Government funding for essential needs

Lastly, central banks can use their balance sheets to provide governments with emergency financing. This is evocative of one of the roots of central banking: the funding of the war. Currently, there are legal restrictions on central banks directly financing the government to prevent abuse. Given that this cannot be ruled out under all circumstances, there should be a system describing how and when this may occur and the central bank's road to regaining its independence. If implemented, this could eliminate the need for quantitative easing.

How it relates to the gilt crisis last week?

Prior to the 2008 normalization of quantitative easing, OMOs were always the norm for central banks seeking to mitigate temporary market anomalies. Since 2008, these operations have become permanent. As a result de facto, "permanent" asset purchases were primarily regarded by the public as money printing. In reality, it is more of an asset swap. The sad reality is, if the market perceives it as money creation, then it is money printing.

Nevertheless, QE-style asset purchases were purely a result of the zero lower bound. They were a result of banks' inability to stimulate the economy through rate decreases. Clearly, this is not the situation today. The market has misunderstood the entire Gilt panic situation. It is not a typical QE-style purchase of permanent assets. It is more comparable to an Open Market Op or a Market Intervention (OMO). The hint is contained within the BoE's market notification. Temporary, targeted, and intended to "establish orderly market conditions." This is not quantitative easing. These are OMOs.

In light of this, the actions of the central bank are neither irrational nor inconsistent with a rate-hiking regime. It is the result of daily funding constraints and plumbing concerns. The reason the plumbing cannot readily handle these stressors is that it is still designed around whole-day funding rather than real-time needs-based funding.

The BoE signal was obscured by the noise. It is unfortunate that the entire situation has been taken over by politics and the British media's persistent concern with self-flagellation regarding UK-related matters.

From the flip side, the crux of our thesis is that these five active types exist and that countries (or currency zones) require a regime for each. The central banks must answer the "what are you doing and why are you doing it?" with clarity to avoid this type of misunderstanding.


Central banks have been reformed over the previous 15 years, albeit under significant pressure due to fiscal authorities' passivity before the global financial crisis. Regardless of the settings, a review of the diverse uses of central bank balance sheets over the past decade indicates fundamental flaws in the framework governing their operations. Their legal authority may be unambiguous, but we do not observe any regimes with clearly defined purposes, objectives, and constraints, except for monetary policy, as it is typically understood. This renders the public and its representatives incapable of monitoring central bank policies appropriately. In addition, the governance of the various forms of balance sheet operations is sometimes unclear or changing. This pertains to activities done as the lender of last resort to non-banks, market maker of last resort, provider of selective credit support, and backstop banker for the government.

Regardless of the five types of balance sheet operations legislators choose to permit; each must have its regime and fit into a coherent overall structure. Concerning coherence, we argue that the ultimate objective for using any central bank instruments should be specified in terms of the stability of the monetary system and, subsequently, the economic function of safe assets. Notably, the validity of our fivefold classification is independent of what we or others regard as the central bank's primary mission.

The present institutions supporting monetary policy (as popularly understood) provide a road map for the development of specific regimes for each sort of balance sheet operation permitted. As part of each, whenever the central bank takes action, the relevant decision-making body inside the central bank should be transparent and reveal precisely what it is doing and why holding the regulators and their relevant colleagues accountable. Then, it would be less likely that quantitative easing, the lender of last resort, the market maker of last resort, selective credit support, and emergency government financing would be grouped and characterized as "monetary policy."

  1. Cecchetti, S. G. (2008). Federal Reserve policy responses to the crisis of 2007-08: A summary. VoxEU. org (April 10, 2008), http://www. voxeu. org/index. php.

  2. Gilchrist, S., Wei, B., Yue, V. Z., & Zakrajšek, E. (2020). The Fed takes on corporate credit risk: An analysis of the efficacy of the SMCCF (No. w27809). National Bureau of Economic Research.

  3. Power, U. (2018). Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State.

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How BoE policy confusion played part in gilt meltdown - an important categorization of CB toolkit

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