Central banks: A balancing act

One of the issues which central banks are going to have to face up to at some point in future is the question of whether and how to reduce their balance sheets, which have been swollen by the huge purchases of financial assets under the QE programme. The balance sheet of the US Federal Reserve, for example, now stands at $4.5 trillion, which is roughly 25% of GDP compared to a figure around 7% at the start of the financial crisis, with the expansion comprised primarily of Treasury and Mortgage Backed Securities (MBS).

From the outset, central banks were clear that it was the stock of assets held on the balance sheet which was important for the purpose of injecting additional liquidity, not the rate at which they were purchased. This was because the purchase of bonds has a counterpart on the liability side of the balance sheet in the form of a credit to the banking system (excess reserves), representing the transfer of funds from the central bank to the seller of the bond. To the extent that the banking system creates liquidity as a multiple of the deposits in the system, this rise in banking sector deposits held at the central bank is what ultimately determines the pace of liquidity creation in the wider economy. The Fed ceased buying assets in October 2014. But as existing bonds matured so they ceased to be an item on the asset side. In order to prevent an unintended decline in the balance sheet, it was forced to rollover maturing securities which means that it is still actively buying assets, albeit on a smaller scale than previously.

But the Fed has indicated that it will ultimately shrink its balance sheet, and thus impose an additional degree of monetary tightening, but not until “normalization of the level of the federal funds rate is well under way.” Whilst markets are concerned about when this is likely to happen, a more interesting question is how rapidly it is likely to proceed. It is widely anticipated that the Fed will allow its maturing bonds to simply disappear from the balance sheet – a form of passive (or less active) reduction compared to the alternative of actively selling bonds. Ben Bernanke (amongst others) has argued that the Fed should simply aim for a given size for the balance sheet and allow the maturing of existing bonds to continue until the desired level is reached.

It is pretty likely that wherever we do end up in the longer-term, the balance sheet will not go back to pre-2008 levels. With Fed estimates indicating that demand for currency is likely to reach $2.5 trillion over the next decade, compared to $1.5 trillion today (and $900bn before the crisis), it is evident that the absolute size of the balance sheet in the longer term will be far higher than it was 10 years ago. In one sense, this makes the Fed’s task easier because it will not have to run it down so far. Indeed, in a nice little blog piece in January, Ben Bernanke reckoned that the optimal size for the balance sheet over the next decade is likely to be in the region of $2.5 to $4 trillion. If indeed the optimal size is close to the upper end of the range, it implies that the degree of reduction will be very small indeed, and would have little impact on markets which fear that a rundown of the balance sheet will result in a sharp rise in interest rates.

This absence of a dramatic reduction would be in keeping with past historical evidence. Analysis by Ferguson, Schaab and Schularick which looks at central bank balance sheets over the twentieth century, argues that prior to the onset of the financial crisis balance sheets relative to GDP were very small relative to the size of the economy compared to longer-term historical experience. They also note that “outright nominal reductions of balance sheets are rare. Historically, reductions have typically been achieved by keeping the growth rate of assets below the growth rate of the economy.”

Perhaps what this all means is that we should stop worrying too much about the potential impact of big central bank balance sheet reductions. But it does mean that a more permanent change in the conduct of monetary policy is about to take hold. Prior to 2008, central banks controlled access to demand for banking sector liquidity by regulating its price via the overnight rate. Now that liquidity is plentiful, both the Fed and ECB operate a floor system by controlling the rate they pay banks on reserves held with the central bank. As recently as November 2016, the FOMC described the current floor system as “relatively simple and efficient to administer, relatively straightforward to communicate, and effective in enabling interest rate control across a wide range of circumstances.”

Such a policy requires the banking system to be saturated with reserves and implies that the balance sheet may be about to assume a more important role in the conduct of policy as it becomes the tool via which bank reserves are supplied. So maybe central bank watchers will spend less time worrying about the policy rate in future and we will go back to the old-fashioned job of trying to predict how much liquidity central banks are injecting into the market. Now that takes me back a bit …