Note dated 10th Feb 2011. I’ve completely changed and re-drafted the article below, partially as a result of what I learned from Winterspeak’s article on the possibility of central banks going bust (26th Feb 2011). That’s the beauty of blogging: what you learn. (Thanks to Tom Hickey for alerting me to Winterspeak's article.)
Yves Smith and Willem Buiter claim that when winding down QE, a central bank (CB) might make a large loss because the value of the relevant securities has dropped. Moreover, the loss might be so large that the CB will not be able to escape the problem by printing more money if inflation looms: any such money printing operation would simply exacerbate the inflation.
The latter claim is wrong by 180 degrees and for the following reasons.
Any loss made by a CB is profit in the hands of the private sector, the effect of which is likely to be stimulatory and/or inflationary. In this scenario, what the CB needs, far from being more printed money, is the opposite: that is, some form of “money mopping up” tool or deflationary tool.
The traditional deflationary tool used by CBs is interest rate increases – effected by selling government bonds. But what if the CB has taken QE as far as it can and sold ALL its government bonds? It is then in uncharted territory.
It could announce it was willing to borrow at above the going rate, and raise interest rates that way. I’m not an expert on the law governing CBs, but I imagine the law in some countries permits this ploy while others do not. Anyway, that’s a minor technical / legal problem.
The bigger problem is that it is debatable as to whether the latter ploy would be deflationary. Reason is that in order to pay the interest, the CB has to print money, and the net effect is to increase financial assets in the hands of the private sector, which does not sound desperately deflationary to me.
Put another way, private sector entities do not do deals with CBs unless those private sector entities think there is profit in the deal. And making a profit is liable to result in stimulation and/or inflation.
In this situation, the CB could be in a bind or “bust” in the sense that it would need to go cap in hand to the government or Treasury and ask it to collect extra taxes to fund the latter interest payments. After all, there is a big difference between, first, offering the private sector higher interest payments where the money for those payments has been confiscated from the private sector, and second, offering higher interest payments with printed money.