Credible lenders of last resort use price, not quantity signals

Let’s talk about credible government bond backstops for a bit.

Short-rates

The Federal Reserve is a monopolist. The US government, as monopoly issuer of its own currency, has given the Fed monopoly power in the market for base money. The Fed exercises this monopoly power by targeting the overnight rate for money, the fed funds rate.

In fact, almost all modern central banks of today operate with explicit interest rate targets, allowing the overnight rate to fluctuate within a range. For example, the Federal Reserve has set the target range for the federal funds rate at 0 to 1/4 percent.

The point is modern central banks use a price rule in targeting interest rate, not a quantity rule as in targeting reserves or monetary aggregates.

Any monopolist can only control either price or quantity, not both. And central banks want to target rates i.e. price. They can’t do that unless they supply banks with all the reserves the banks desire to make loans at that rate. This means that central banks must be committed to supplying as many reserves as banks want/need in accordance with the lending that they do subject to their capital constraints. Failure to supply the reserves means failure to hit the interest rate target.

Here’s how it works. The Fed announces a target and stands at the ready to defend that target via repos or reverse repos if the market doesn’t move to the rate. But the market does move because punters know that the Federal Reserve can literally print unlimited quantities of money to make good on their policy rate commitments.

Long-rates

Hence, markets know that the Fed, as a monopolist, will always be able to hit its federal funds target now and in the future. Therefore, future overnight rates reflect only future Fed Funds target rates as set by the Federal Reserve. This means that future expected overnight rates reflect only market-determined median expectations of future Fed Funds target rates as set by the Federal Reserve (plus a risk premium). Long-term interest rates are a series of future short-term rates. All I need to do to mathematically represent any long-term interest rate is smash together a series of short-term interest-rates over the long-term period.

Since central banks are monopolists for base money and the link between the target rates they set with their monopoly power and longer-term interest rates are expected future policy rates, the principal way that central banks control long-term interest rates is through changing expectations of those future policy rates.

For example, in August the Fed told us that:

“The Committee currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

They didn’t have to buy any two-year bonds for this policy to have its effect. The market did it for the Fed – just as the market does it for fed funds. Instantly, the yield on the two-year treasury note dropped 19 basis points. Such is the power of the central bank.

Quantitative easing and similar schemes are about quantity, and are therefore ineffective. Central banks using quantity targets to increase nominal GDP fail.

Lender of last resort

I hope the preceding discussion makes clear that central banks control interest rates for the government bonds in their currency in a way that means that the only meaningful variable in determining rates is the uncertainty about future policy paths. If a central bank is explicit and credible about the exact future policy path it will follow, rates will adjust accordingly.

What does that mean for a central bank as lender of last resort then?

1. Central banks target price i.e. rates and are the monopoly supplier of reserves. They can target any rate of any maturity in any debt instrument denominated in the currency for which they are the monopoly supplier of reserves. If a central bank is explicit and credible about defending its target price i.e. rate for a specific debt instrument at a specific maturity, the rate for that debt instrument will move to the central bank’s rate without the central bank necessarily having to buy a single bond.
2. Therefore, subject to prevailing law and legislative approval, central banks can control the price of any asset for which they are the monopoly supplier of reserves. For example, if the Federal Reserve so chose, it could set a specific price for California 6-month general obligation municipal bonds. Or the ECB could set a target spread for 10-year Italian paper at 200 bps to German Bunds.

Conclusion: For the ECB, it’s not about buying up Italian debt or Greek debt. It’s about credibly defending specific financial assets as the monopoly supplier of reserves with a specific target price. Central banks are price-targetting monopolists. They can only be effective if they realise this affects everything they do. The role of the lender of last resort is about price, not quantity.