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The challenge of monetary tightening

When it was announced on September 13 that the consumer price index, a key measure of inflation, in the United States had risen more than expected in August, stock prices plummeted and the US dollar appreciated sharply. Markets knew this would prompt the US Federal Reserve to announce another significant interest rate hike. And that’s exactly what

happened. But the pain of monetary tightening is just beginning.

The Fed is not alone in raising interest rates. Skyrocketing inflation, which has reached double digits in the European Union and the UK, has prompted the European Central Bank and the Bank of England to do the same, though many economists still accuse the three monetary authorities of lagging behind. .

The central banks of Indonesia, South Korea and Thailand also raised their policy rates by 25 basis points, and the Philippine central bank by 50 basis points, in August. Inflation stood at 7.9 percent in Thailand, 6.3 percent in the Philippines, 5.7 percent in South Korea and 4.7 percent in Indonesia in the same month. One Asian economy that is not struggling with skyrocketing prices is China. With inflation running at 2.5 percent, the central bank lowered its key interest rates last month. For China, the biggest challenge, and the main reason inflation has not spiked, is falling economic growth, largely due to the government’s zero-Covid policy. The slowdown is putting the over-leveraged real estate market under severe pressure.

Then there is Japan. After years of below-target inflation and even deflation, rising energy and food prices pushed core consumer inflation to 2.8 percent in August, the fastest annual rise in eight years. But excluding fresh food and energy, the inflation rate was just 1.6% in August, still below the 2% target. This explains why the Bank of Japan (BOJ) has yet to abandon negative interest rates or yield curve control (limiting the rate on ten-year bonds to 0.25 percent). As the interest rate differential between Japan and the US widened, the yen/dollar exchange rate also swung sharply toward yen depreciation. With the yen depreciating by nearly 30 percent in the past 12 months, the dollar’s exchange rate now hovers around 144 yen, a level last seen in 1998, during the Asian financial crisis.

Japan cannot maintain loose monetary policy forever. In fact, you should already be getting ready to squeeze. And interest rate hikes are not the only way to pursue this goal. Central banks may also shrink their balance sheets, which have expanded significantly since the 2008 global financial crisis, when monetary authorities began buying large amounts of long-term bonds as part of their quantitative easing (QE) programs. One way to accomplish this is to let maturing bonds roll off balances, rather than reinvest them.

There is a risk here. Before a central bank has cleared its balance sheet of enough long-term bonds, rapidly rising interest rates will drive down the market value of the bonds, even if the value of the liability remains unchanged. This could push a central bank into “technical insolvency,” with the market-adjusted value of the liability exceeding the market-adjusted value of the asset by more than the sum of principal and any buffers (accumulated retained earnings). Japan may be particularly vulnerable on this front, given that it has long held a near-zero long-term interest rate. The average maturity of bonds on the asset side of the BOJ balance sheet is estimated to be 6.5 years, and their average yield is extremely low. However, in reality, a technical insolvency would not be an event. Unrealized losses are not a problem for a central bank that almost always holds bonds to maturity.

But central banks may face another problem as interest rates rise. A central bank earns its income from interest on its assets (mainly government bills and bonds) and pays interest on interest-bearing reserves. The Fed began paying interest on excess reserves in October 2008, due to the expansion of its balance sheet; the BOJ did the same the following month. This was not a problem at the time, because the interest paid on the reserves is basically equal to the policy rate, which has been close to zero, while the interest rates on Treasury bills and bonds (or government bonds Japanese) have been positive, although with a downward trend. . The interest spread between assets and liabilities generated large profits for central banks, known as seigniorage, which are passed on to the government. Large and rapid increases in interest rates cut into these gains, as the interest paid on the liability side rises in line with policy rates, but most Treasury bonds have fixed rates. If policymakers aren’t careful, interest payments can exceed revenues and even eat up any cushion the central bank may have. The result is so-called negative seigniorage, which requires the government to provide subsidies to the central bank, which could pose a political problem.

For the BOJ to avoid negative seigniorage, it must not rush the reduction process. In addition, it must allow the long-term interest rate to rise, raising the cap on the ten-year bonds, before moving (slowly) to raise the policy rate. The question is whether the economic and financial evolution of the coming years will allow this approach. When central banks launched QE, the risks of technical insolvency and negative seigniorage were widely recognized. But the governments backed the monetary authorities. The Federal Reserve balance sheet was supposed to be backed by an implicit government guarantee. The UK government guarantee was more explicit. And the government of Japan allowed the BOJ to accumulate retained earnings. However, as monetary tightening progresses, these commitments could be tested. Crucially, if negative seigniorage arises, governments must refrain from making it a political issue.


The writer, a former Japanese deputy finance minister, is a professor at Columbia University’s School of International and Public Affairs. © Project Syndicate, 2022

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