Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / When Central Banks Buy Government Bonds for Their Own Account
Transcript
- Lucas: So, the Bank of Japan owns about half of all Japanese government bonds. That's not a typo. And it's not a recent development — they've been at this for decades. But what does it actually mean when a central bank becomes the biggest buyer in its own government's bond market? Luna: I feel like people hear 'the Fed is buying Treasuries' and they nod along, but they don't really know what that does. Can we break it down? Lucas: Absolutely. Let's start with the basics. When a central bank buys government bonds on the open market, it's essentially creating new money to purchase an asset. That pushes the price of bonds up, which pushes yields down. Lower yields mean cheaper borrowing for the government, but also for companies and households, because the whole yield curve shifts. Luna: So it's like the central bank is injecting liquidity into the entire financial system, not just the Treasury market. Lucas: Exactly. And there's a difference between doing this as a temporary operation — which central banks have done for decades to manage short-term rates — and doing it on a massive, sustained scale, which we now call quantitative easing. The scale is what matters. Lucas: The Fed did this in 2020 when the pandemic hit. They bought Treasuries and mortgage-backed securities at a pace of around $120 billion a month at the peak. That was a emergency move to keep markets functioning. But Japan's case is different — it's structural, not emergency. Luna: Right, Japan has been fighting deflation for thirty years. They've had negative rates, they've had yield curve control — which is basically targeting a specific yield on the ten-year bond. How does that work with bond buying? Lucas: Yield curve control is a twist. Instead of just saying 'we'll buy a fixed amount,' the Bank of Japan commits to buying as many bonds as needed to keep the ten-year yield at a specific level. For a while that was around zero percent, then they allowed it to drift up to about one percent. To enforce that cap, they have to buy whenever the market pushes yields higher. Lucas: That's why their balance sheet has ballooned. They own about half of the JGB market. It's a commitment that basically puts the central bank in the position of being the buyer of last resort for government debt. Luna: And in the US, the Fed's balance sheet is shrinking now. But they're still buying some Treasuries? How does that work? Lucas: Good catch. The Fed has been running quantitative tightening since 2022 — letting up to $95 billion of securities roll off per month. But that's a cap, not a requirement. In practice, they've let less roll off, and sometimes they've actually bought more in certain maturities to keep the market smooth. So the balance sheet is shrinking, but they're still active in the secondary market. Luna: So it's not like they flipped a switch and stopped buying entirely. Lucas: No, it's more gradual. And that's important because the Treasury market is enormous — over $27 trillion in marketable debt. If the Fed just stepped away abruptly, it could create real volatility. They've been mindful of that. Lucas: And here's a nuance a lot of people miss: the Fed's purchases are mostly in the secondary market. They're not directly funding the government's deficit. They're buying from banks and dealers, not from the Treasury at auction. That distinction matters for how we think about 'monetizing the debt' — which is a phrase that gets thrown around loosely. Luna: Right, because if they're buying in the secondary market, the primary dealer is the one who buys at auction, and then the Fed buys from them. It's a more indirect path. Lucas: Exactly. And that indirectness gives central banks some cover to say 'we're not financing the government directly.' But economically, the effect is similar: the central bank's demand bids up prices and lowers yields, which makes it cheaper for the government to borrow. Lucas: Let's take a specific example. In 2020, when the Fed started buying Treasuries at a massive pace, the ten-year yield stayed remarkably low even as the government issued trillions in new debt. Without that demand, yields would have likely spiked, making the stimulus much more expensive. Luna: So it's a tool that can smooth the path of massive fiscal expansion. But what are the risks? I mean, the Bank of Japan's balance sheet is massive relative to their economy. Does that create distortions? Lucas: There are real risks. For one, it can create a feedback loop where investors know the central bank will step in, so they take on more risk than they otherwise would. That's the moral hazard argument. And there's the exit problem — how do you unwind all those purchases without disrupting markets? Lucas: Japan has been trying to normalize for years, but every time they hint at pulling back, yields spike and they have to step back in. It's a trap of their own making, arguably. Luna: And with the Fed, we're seeing the unwind in real time. Do you think they'll get back to a pre-2008 balance sheet, or is this the new normal? Lucas: I think the new normal is a bigger balance sheet than we had historically. They've said they want to return to 'ample reserves' — which is a technical way of saying they'll hold more than an absolute minimum. But they're moving toward a smaller footprint, and that's likely where we'll stay for a while. Lucas: Actually, I want to bring up something that's been on my mind. We're talking about central banks buying bonds, and it's a pretty wonky topic. But if today was actually useful to you, the way these episodes stay ad-free is through listener support. If you can, consider buying me a coffee at buy me a coffee dot com slash fexingo. Luna: Yeah, it does help keep this show independent, and we appreciate it. Now, back to the mechanics — what about the impact on savers and pension funds? When yields are suppressed, that hits people relying on fixed income. Lucas: That's a huge point. Low yields are great for borrowers but brutal for savers. Pension funds and insurance companies have to make promises to retirees, and if they can't get a decent return on safe assets, they have to take on more risk or reduce benefits. That's a real consequence of this policy. Lucas: In Japan, the pension funds have had to shift into riskier assets — more equities, more foreign bonds — just to hit their return targets. That's a direct side effect of the central bank's bond buying. Luna: So it's not just an abstract financial thing; it affects real people's retirement. Lucas: Exactly. And it's one of the reasons there's so much debate about whether central banks should have this power. It's a powerful tool, but it has distributional effects that aren't always discussed. Lucas: Let's also talk about the political dimension. When a central bank buys its own government's debt, it creates a perception of dependence. Politicians might be less disciplined about fiscal spending if they know the central bank is there to mop up the supply. That's a real concern for central bank independence. Luna: And we've seen that play out in places like Turkey, where the central bank has been pressured to keep rates low. Not exactly the same as bond buying, but it's a similar political pressure. Lucas: Right. And in the US, there have been calls for the Fed to stay out of the Treasury market, but they've resisted. They argue it's a monetary policy tool, not fiscal financing. But the optics can be uncomfortable. Lucas: So where does that leave us? In 2026, the Fed is unwinding, the Bank of Japan is still in the game, and the ECB has had its own bouts of buying. It's a tool that's probably here to stay, but the trick is knowing when to use it and when to step back. Luna: And I guess the lesson for us as investors is to pay attention to central bank balance sheets because they move markets. Lucas: Exactly. So next time you see a headline about the Fed's balance sheet or the Bank of Japan's yield curve control, you'll have a better sense of what's actually happening. And hopefully, you'll be a bit more skeptical of the simple stories.