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Julian D. A. Wiseman
Abstract: the Bank of England should cease selling 1-week BoE Bills, and, relatedly, should not target the banking sector’s reserves.
Publication history: only here. Usual disclaimer and copyright terms apply.
Contents: Introduction; Short-term ‘draining’ operations; On reserves.
On Thursday 5th March 2009 the Bank published Sterling Monetary Framework; Asset Purchases, announcing various matters relating to the start of ‘Quantitative Easing’. That same day this author wrote a short note commenting on some of the features, good and bad, of the BoE notice. These words expand on that short note.
The BoE is engaging in some ‘quantitative easing’, that is, spending money being issued for the purpose, and has announced that it will pay interest, at the policy rate, on reserves balances. Given that, imagine that the BoE is to choose between the following.
At 4pm each day the BoE is to conduct an auction of 1-day BoE Bills; or
The BoE doesn’t so drain reserves, and instead pays the policy rate on these reserves.
The first would lower the measured level of reserves, because balances in the reserve accounts would become balances in a securities account. But otherwise the two courses of action would be functionally equivalent.
But the Bank is doing a version of the former, with 1-week substituting for 1-day. Why? The BoE has not said that it is explicitly targeting reserves, but the decision to sell Bills suggests that the Old Lady is effectively targeting reserves. So, next question: bank-by-bank reserves targeting having been wisely abandoned, what is achieved by targeting, even informally, the system-wide level of reserves?
A bank can use its reserves account to make payments. Having more in the reserves account reduces the probability of being unable to make a payment; having less increases the probability of such an accident. So the commercial banks should charge for this additional risk by demanding a yield on the 1-week BoE Bill that is above the compounded expected policy rate. If the commercial banks do charge for this risk, the BoE incurs a needless loss. If the commercial banks don’t charge for this risk—well, undercharging for liquidity risks has already given plenty of trouble.
So the commercial banks, having bought these BoE Bills, have an increased probability of an accident. The BoE’s small financial loss has bought an increased risk of accidents.
But perhaps the draining operations have a presentational benefit. Ceasing to drain would raise reserves by some £48bn, and the BoE might not want to have to explain this rise. Inflation-targeting monetary policy is, in good part, about expectations targeting, so in principle this could be a sufficient reason. But draining operations are a technical tweak understood by few people in markets, and even fewer outside. An explanation (or even, less probably, a link to this page) would give journalists the clues they need. They would ask market contacts, who would confirm that the change in reserves is a technical feature of no economic import. Thus presentation seems an insufficient reason to drain.
Lastly, it adds complexity. This isn’t good.
In summary, the only real effects of the draining operations are bad. Please don’t—and not doing so requires not targeting reserves.
There are some very natural measures in finance, that capture the essence of a real something. An example is net worth, particularly for small entities. Net worth is the market price of assets, minus the liabilities discounted at a perfect-credit interest rate. This captures the breakup-and-sale value of the entity. It is the no-messing-around value: it is something with real meaning and import.
Another number that is quoted, most often by central banks, is reserves. Money in a remunerated reserves account is economically identical to a 1-day bill issued by the central bank, but only one of these two counts as reserves. So the system’s reserves can be moved up or down without causing any other economic effect. This very strongly suggests that reserves are not a real thing with real meaning and import, and hence definitely not a sensible thing to target. Please, Old Lady, and other central banks, don’t target reserves, neither formally nor informally; don’t ‘shadow’ reserves, nor do anything else with reserves that can be described by any verb meaning something similar. Reserves are not a natural thing describing something useful, and hence they should not be targeted.
— Julian D. A. Wiseman
New York, 9th March 2009
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