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Why a decade of QE has not (yet) created an inflationary spiral

Why a decade of QE has not (yet) created an inflationary spiral

I am often asked what I understand by debt monetization, so let me explain it. Think of a government’s nominal liabilities as either currency, central bank reserves or Treasury debt.

Currency and central bank reserves are both considered money, whereas Treasury debt is not. To finance a deficit, governments need to issue Treasury debt. 

The burden of servicing that debt can be reduced dramatically if the central bank can transform interest-paying Treasury debt into zero-cost reserves - ie money.

In practical terms, that is accomplished by allowing the central bank to buy large amounts of Treasury debt in the secondary market. If BoE owns about one-third of all UK government bonds (as it does), the UK government’s interest burden is approximately a third lower than it would otherwise be. The act of converting debt to money is what is often called debt monetization.

Many commentators distinguish between debt monetization and full debt monetization. The difference between the former and the latter is quite simple. When debt is fully monetized, the central bank will hold it to maturity, and the debt will be cancelled (forgiven).

When all the government debt held by BoE eventually matures, BoE will have (at least) two options. It can either (a) opt for a very conventional exit; ie the UK Treasury will have to repay BoE what is owed, or it can (b) cancel (forgive) the debt. In that case, the UK Treasury won’t have to cough up a single penny.

Relatively recent research from the Federal Reserve Bank of St. Louis suggests that the inflationary impact of debt monetization, and possibly even full debt monetization, can be kept in check by managing interest rates correctly

The trick is to make it unattractive for commercial banks to lend, and that can be done by keeping short-term very low and, when they finally begin to rise, to increase the rate of interest commercial banks earn on any reserves held by the central banks, as the Fed has done since 2015.

According to St. Louis Fed, in the 20 years between the mid-1950s and the mid-1970s, not only was the spread between short-term interest rates and the rate of interest on reserves rising; it was also quite high in absolute terms, averaging about 5% (see chart below).

One-year Treasury yields and interest rates on reserves 1953-74

SOURCE: St. Louis Fed

With such a high spread, commercial banks had a strong incentive to lend rather than just sit on their reserves. Making all those loans would boost the profitability of the banks, but broader money supplies would also increase, having the effect of driving inflation higher.

Now, compare that to the same spread between 2009 and 2017 (graph  below). As you can see, for much of the time, the spread was virtually non-existing, which made it preferable for banks not to lend.

Spread between one-year Treasury yield and interest on reserves, 2009-17

SOURCE: St. Louis Fed

The spread even turned negative between 2011 and 2015, meaning that banks would make more money if they just sat on their reserves.  No wonder there was, and still is, little inflationary impact from debt monetization in this economic cycle.

As you can also see, in 2015 when the yield on US Treasury bills began to rise, the spread was still non-existing as US banks started to earn interest on their reserves; ie the Fed controlled inflation by making it relatively unattractive to lend.

It will be very interesting to see what BoE opts to do when all the Treasury debt it holds eventually matures. Sir Mervyn King, the previous BoE Governor, was dead against full debt monetization as he thought that would turn the UK into another Zimbabwe, but is it all about how interest rates are managed?

Niels Clemen Jensen is founder & chief investment officer at Absolute Return Partners and a Citywire Wealth Manager columnist. he is the author of the recently published The End of Indexing

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