Project Syndicate: Central banks want to fight inflation, but they still need to keep the financial system functioning. The two goals may be conflicting.

by | Oct 8, 2022 | Stock Market

After two years of quantitative easing, central banks have begun to shrink their balance sheets, and liquidity seems to have vanished in the space of just a few months—revealing acute financial-system vulnerabilities. It is now clear that monetary-policy normalization will be exceedingly difficult and fraught with risk.

CHICAGO (Project Syndicate)—The malfunctioning of the government bond market in a developed economy is an early warning of potential financial instability. In the United Kingdom, the new government’s proposed “mini-budget” raised the specter of unsustainable sovereign debt and led to a dramatic widening in long-term gilt yields
TMBMKGB-10Y,
4.235%.
Recognizing the systemic importance of the government bond market, the Bank of England correctly stepped in, both pausing its plan to unload gilts from its balance sheet and announcing that it will buy gilts over a fortnight at a scale near that of its planned sales for the next 12 months. Markets have since calmed down. But as commendable as the BOE’s prompt response has been, we must ask what blame central banks bear for financial markets’ current fragility. After all, while long-term gilt yields have stabilized, gilt market liquidity (judging by bid-ask spreads) has not improved.

“ In the case of the United States, QT makes conditions even tighter still, because the financial sector does not quickly shrink the claims that it has issued on liquidity, even as the central bank takes back reserves. This, too, makes the system vulnerable to shocks—an accident wait …

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