MNI POLICY: BOE, ECB Probe Whether QT Can Lower R-Star
MNI (LONDON) - Quantitative tightening, which causes central banks’ reserves to fall as they sell off their bond holdings, can in some circumstances push down on the neutral level of interest rates, according to research from the Bank of England also garnering attention at the European Central Bank.
The research on the link between QT and “R-star” may imply that current policy rates could have further to fall while still remaining restrictive, and also that central bank reserve management should be factored into estimations of neutral, now largely determined by real economic factors and demographics.
While increasing the free-float of sovereign debt will tend to push up yields – with IMF studies pointing to a 4-basis-point rise in the risk-free rate for ever every percentage-point increase in the market supply of government debt, the BOE research model points to how on the other side of the ledger at some point scarcity makes commercial banks accept lower returns on the remaining reserves.
FRANKFURT FOCUS
ECB Executive Board member Isabel Schnabel cited the work by BOE research hub chief Michael Kumhof and economist Mauricio Salgado-Moreno at the recent BOE BEAR conference, saying the net effects of QT on the real equilibrium rate depend on the relative strength of these two countervailing factors. "If QT leads to a scarcity of reserves, it may cause the overall convenience yield to rise, and hence equilibrium rates to fall,” she said in a speech.
Schnabel has in recent months argued that the ECB’s policy rate may not have far to fall, if at all, before it exits restrictive levels. But the BOE research she cited suggests that R-star could be lower than previously assumed, pointing to more scope for a rate reduction.
The ECB continues to look at the impact of QT on its monetary policy, with another Executive Board member, Piero Cipollone, saying policymakers must be aware of transmission risks as the balance sheet reduces in size.
IMPACT ASSESSMENT
The BOE work provides no easy answers in quantifying the relative effects of greater bond supply and tighter reserves. The impact of lower reserves is assumed to be non-linear - reflecting the idea that if they are really scarce then banks would be willing to accept disproportionately lower interest rates on them. Evidence from the U.S supports this - when reserves have dipped low the interbank interest rate has gone up, and when reserves are very scarce it has gone up significantly.
The BOE's recent summary of work on R-star, published in the February Monetary Policy Report made no mention of the impact of shrinking reserves. The idea looks set to gain traction, however, with ECB work on it in the pipeline and with central banks repeatedly revisiting their estimates of neutral at a time when they are lowering their policy rates.
And yet the BOE researchers' idea that central banks themselves may be key players in determining R-star has a long heritage, with Claudio Borio from the Bank for International Settlements having warned about the risks of assuming that neutral is independent of monetary policy.