Where is the way out? Central banks in multiple countries are trapped in a cycle of "firefighting - leveraging - and firefighting again."

Central banks around the world are facing a tricky paradox: the rescue tools designed to prevent market collapse are creating new risks. On August 15, The Wall Street Journal reported that Huw Pill, the chief economist of the Bank of England, and other policymakers have begun to publicly express concernsanti-crisis mechanisms not only enhance leverage but may also quietly interfere with the transmission of monetary policy. Pill described this dilemma as a game of "whack-a-mole": Ironically, the vulnerabilities are precisely created by the mechanisms introduced to mitigate those vulnerabilities. Currently, this cycle has entered a new phase of leverage accumulation, and no effective way to break the deadlock has been found. Role Shift: From "Lender of Last Resort" to "Market Maker of Last Resort" The traditional role of central banks is as a "lender of last resort"providing liquidity support during bank runs. However, during the 2008 financial crisis and the 2020 COVID-19 pandemic, major central banks, such as the Federal Reserve and the Bank of England, further expanded their roles to become "market makers of last resort," directly intervening in corporate and government bond markets to ensure they operate normally. According to The Wall Street Journal's analysis, market support during times of crisis is often necessary to prevent the financial system from spiraling into collapse. The issue lies in the fact that once market participants form the expectation that the central bank will provide a backstop, they will take on more risks and use higher leverage. This logic is particularly evident in the U.S. Treasury bond market. Leverage Inflation: Hedge Funds Hold $2.4 Trillion in U.S. Treasuries According to estimates from the Federal Reserve Bank of Dallas, hedge funds are expected to hold $2.4 trillion in U.S. Treasuries by the end of 2024, compared to just $600 billion a decade ago. These funds are mainly used for two types of arbitrage trades: one is the "basis trade" between Treasury bonds and Treasury futures, and the other is arbitrage between Treasury bonds and interest rate swaps. Given that the profit from individual trades is extremely thin, hedge funds must use leverage as high as 100 times to achieve substantial returns. The cost of high leverage is a vulnerability. In 2020, the collapse of basis trading in U.S. Treasuries prompted the Federal Reserve to intervene urgently in the market; by 2025, signs of turmoil appeared in swap trading, prompting the Trump administration to make concessions on tariff policies. Implicit Subsidies: Central Bank Backstops Lower Government Borrowing Costs Pill further pointed out in a media interview that this mechanism is effectively lowering government bond yields, functioning as an implicit subsidy for government borrowing. He explained this logic chain: "There are a large number of UK government bonds that need to be absorbed. How can we support the purchase of these bonds? By making them attractive. How do we make them attractive? There are imperfections in the market that create arbitrage opportunities, but the profits are minimal. How do we make those profits meaningful? By allowing leverage to accumulate." "This is beneficial for the government because it can sell bonds at lower yields. It benefits the financial sector because they can extract rent from this. It benefits the central bank because the market appears to have ample liquidity and is functioning normally. But all of this holdsuntil it no longer holds." Pill also expressed concern that this implicit guarantee could "seep" into monetary policy, stimulating borrowing, lowering bond yields, and undermining the effects of monetary tightening. Historical Lessons: The "Powder Keg" Left by QE The report cited Pill's view that the massive bond purchases (quantitative easing) by central banks in 2020, while stabilizing the market, also left behind excess liquidity. This excess liquidity became a "powder keg" after the energy crisis triggered by Russia's invasion of Ukraine, exacerbating inflationary pressures and making subsequent monetary policy tightening even more complex. Pill simultaneously mentioned a relatively successful case: in September 2022, the British government's "mini-budget" triggered turmoil in the UK bond market, forcing leveraged pension funds to sell off bonds. The Bank of England, while maintaining a direction of monetary tightening, undertook "temporary, targeted" purchases of government bonds, successfully halting the selling spiral without deviating from overall monetary policy objectives. Rising Moral Hazard: The Precedent of Bank Bailouts in 2023 The report also noted that current central banks are regressing in terms of managing moral hazard. During the American banking crisis of 2023, the Federal Reserve calculated U.S. Treasury bonds at face value rather than market value when accepting collateralmeaning banks effectively received excess support. This emergency rescue tool subsequently evolved into a financing channel actively used even by healthy banks, effectively easing monetary policy through a "backdoor" and forcing the Federal Reserve to tighten the terms before the tool expired. Japan is planning to use the Federal Reserve's emergency lending tool to raise funds to support the yen while avoiding selling off its substantial holdings of U.S. Treasuriesthis operation might mirror the aforementioned model. Searching for Solutions: A Modern Version of the "Bagehot Principle" In facing this dilemma, Pill called for the establishment of a modernized version of the "Bagehot Principle" suitable for contemporary markets. The classic principle proposed by Walter Bagehot, editor of The Economist in the 19th century, is that central banks should lend freely to banks, but only against good collateral and at a penalty rate. The logic behind this design is that it provides liquidity during a crisis while constraining moral hazard through penalty rates, making shareholders pay for excessive risk-taking. However, extending this principle to modern bond markets currently lacks a clear framework. The Wall Street Journal's author James Mackintosh candidly stated, I dont know how to break this cyclecrises require bailouts, bailouts lead to more leverage, and more leverage triggers new crises. I fear we are already firmly in the leverage accumulation phase of the latest cycle. He also noted that at least central bank officials are still contemplating this issue, even though they currently do not have good answers. This article has been reproduced from Wall Street Watch, GMTEight Editor: Chen Yufeng.