The other day, the Federal Reserve (Fed) announced that it will not extend the SLR (supplementary leverage ratio) break, a decision that has surprised the market. Meanwhile, the Dow Jones Index and the S&P 500 fell slightly last Friday, while the Nasdaq Composite rose slightly, and there has been no dumping of US Treasuries for the moment. The market generally expects that even without extension of the SLR break, new measures will be launched to ease the pressure on financial institutions to reduce their US Treasuries. However, the Fed has taken almost zero action. It has only raised the cap on the reverse repo facility to US$80 billion from US$30 billion per day, with a view to absorbing potentially excessive liquidity in the market in the future.

SLR is meant to monitor the weight of risk assets of banks (see the article headlined “Fed chairman makes way for further growth of Treasury yields”). It is calculated as a banking organization’s tier one capital divided by its total leverage exposure. According to the Basel III Accord, banks with more than US$250 billion need to have a three percent SLR, whereas for banks that are deemed most important to the overall financial system the ratio is five percent. Last year, the Fed issued a large amount of Treasuries because of the Covid-19 pandemic. Temporarily excluding US Treasuries and reserves from the SLR will free financial institutions from the constraints of the capital-to-risk assets ratio, enabling them to buy more Treasuries.

The SLR exemption will expire on March 31. Meanwhile, before August this year, the US Treasury Department will have to reduce the amount of money it keeps in its Treasury General Account to US$200 billion. That will lead to a sharp increase in the amount of bank reserves. With a surge of bank reserves and with banks having SLR, banks will have to adjust the weight of their risk assets, which involves actions like selling bonds and issuing preferred shares to boost the size of their capital. All this will lead to big fluctuations in the financial market. The fact that US bond yields have risen sharply may suggest some banks have already acted before the Fed’s announcement. But the Fed believes the fluctuations to be caused will be limited, and that even if there are big changes, there will be measures to tackle them.

Note that there is a consensus between US and European financial officials these days. US Secretary of the Treasury Janet Yellen’s position is that there is no need to talk about expectations of inflation until the inflation rate actually rises significantly. Christine Lagarde, president of the European Central Bank (ECB), has also said the ECB will not comment on short-lived inflation. Taking into consideration the attitude of these officials and the actions of central banks, especially the Fed, one can come to the conclusion that these people are resolved to push for high inflation.

Nonetheless, central banks tend to treat inflation like a man treats a woman he woos. Before inflation is achieved, they are willing to do anything, but once inflation is there, they behave differently. The Bank of Japan (BOJ) is often a pioneer who dares to experience different monetary measures. In 2016, it adopted a yield curve control policy. Last Friday, it announced the decision to widen the movement range of national bonds. Some years ago, BOJ set the 10-year bond yield at zero and allowed interest rates to move up or down by 0.2 percent. Now it has upped the range to 0.25 percent and also decided to remove its annual target of buying six trillion yen in ETFs.

Immediately after the announcement, the Nikkei stock index dropped sharply. It is not that Japan has managed to achieve inflation, but seeing what the US and Europe are doing, it reckons the wave of rising bond yields will sooner or later sweep across Japan. So it decided to act in advance. Using fiscal policy to save the market is a way to gradually withdraw the policy of using monetary policy to save the market. In the process, asset prices will be adjusted.

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