Many forces are pushing central banks to change how they operate: low inflation; hesitant fiscal policy; climate change; anemic growth; financial instability. Low inflation claimed the first scalp, when it led the Federal Reserve to switch to an average inflation targeting regime. Climate change may be the next.
The FT reports that:
This is a big deal, even if it might sound like gibberish at first.
Right now, to stimulate the economy, central banks print money (it’s slightly more complicated) to buy government and corporate bonds from the private sector. The idea is that this lowers bond yields, which lowers interest rates, and moves money into other parts of the economy. In theory, interest rates for governments and corporations fall, and lending should increase to businesses and consumers, stimulating the economy. This is Quantitative Easing.
Today, central banks do this without taking the environment into account. A corporate bond from Shell is the same as a corporate bond Vestas (they make wind turbines). For several years now, people have been saying that central banks should use Quantitative Easing in an environmentally conscious way. This mean that, when it buys a corporate bond from Shell, it should acknowledge that Shell is a polluter. When it buys a corporate bond from Vestas, it should acknowledge that Vestas is not a polluter. It could do so by charging a premium for example.
This has been fiercely resisted to date. The fact that the head of the French central bank, who has a seat on the ECB’s Governing Council, is in favour, speaks to how much the consensus is changing.
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The ECB’s Governing Council met yesterday for their monetary policy meeting. Its a similar story to what we have seen from other central banks in recent months: expansion of monetary stimulus and a verbal commitment that stimulus will stay in place for at least another two years.
Some technical decisions to take note of (skip to the next section if your eyes are going to glaze over at the mention of the PEPP, APP, and TLTRO III)
They are increasing the potential size of their Covid-19 quantitative easing program – The Pandemic Emergency Purchase Programme (PEPP) – by 500 billion, to 1.85 trillion. Importantly, they will continue to reinvest the principals from maturing securities until the end of 2023 – no attempt to reduce balance sheets until then. Put simply, as the bonds they hold mature, and the principal is returned, they will reinvest it in new bonds.
The ECB’s other QE program – the Asset Purchase Programme (APP) – will continue at its 20 billion/month rhythm, with the principals also reinvested.
On the question of winding down QE, Lagarde has said that interest rates will be raised (they are currently negative) before the balance sheet starts to be wound down.
The ECB will improve the terms and conditions of its Targeted Long-Term Refinancing Operations (TLTRO III). The TLTRO programs have been around in various iterations since 2014. Their aim is to preserve the flow of credit by allowing bank to borrow from the ECB very cheaply – at negative rates in fact.Imagine the bank paying you for taking out a mortgage with them.
To qualify for the special low interest rate, banks must meet two conditions. First they have to reach a certain lending threshold (quantity). Second, they must lend the money to non-financial corporations and households, although loans cannot be used for house purchases (quality). This is a very subtle form of credit direction policy
Lagarde reiterates her call for expansionary fiscal policy. Take note of the phrase “medium term.” That could be anywhere from 2-10 years. Its a big shift for a bank that was a driving force for austerity 8 years ago.
Climate policy and central banks
Lagarde has called out how important it is for fiscal stimulus and structural reform to focus on the green transition. Its only words, but it reflects how much the ECB under Lagarde has shifted on this topic. It’s hard to imagine the Fed or the RBA openly encouraging green spending.
To date these proposals have been fiercely resisted, on the grounds it would make central banks too political. However, cracks are emerging within the normally monolithic central banking community. Lagarde has come out and said she thinks climate change has price stability implications. If accepted, this would allow central banks to justify action within their existing mandates. She also hinted that the ECB’s asset portfolio needs to be examined from a green perspective:
In addition, from Jan the ECB will be making slight changes to its bond buying criteria to allow certain ESG (Environmental, Social, Governance) bonds to qualify:
While the arguments of those who favor keeping monetary policy narrowly focused do have some merit, it is time we began to openly debate them. They rely on the pre-crisis hope that monetary policy could be a neutral force and conveniently ignore all the political decisions made since the crisis.
If governance arrangements developed in the 1970s mean central banks can no longer deliver what is required of them by society, let’s re-examine the former, not under-deliver on the latter.