RAGHURAM G. RAJAN and VIRAL ACHARYA
CHICAGO/NEW YORK – 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. 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. And across the Atlantic, the market for US Treasuries is also raising liquidity concerns. Many metrics are flashing red, just like at the onset of the COVID-19 pandemic in 2020 and in the aftermath of Lehman Brothers’ failure in 2008.
After two years of quantitative easing (QE) – when central banks buy long-term bonds from the private sector and issue liquid reserves in return – central banks around the world have begun to shrink their balance sheets, and liquidity seems to have vanished in the space of just a few months. Why has quantitative tightening (QT) produced that result? In a recent paper co-authored with Rahul Chauhan and Sascha Steffen (which we presented at the Federal Reserve Bank of Kansas City’s Jackson Hole conference in August), we show that QE may be quite difficult to reverse, because the financial sector has become dependent on easy liquidity.
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