Central bank balance sheet as a policy tool: past, present and future
Mr. Andrew Bailey, Governor, Bank of England, delivered the opening remarks on the second day of the Kansas City Fed’s annual Jackson Hole Symposium, on 28 August 2020. He spoke on “Central bank balance sheet as a policy tool: past, present and future”, based on a paper (see here) with the same title, prepared jointly with Jonathan Bridges, Richard Harrison, Josh Jones and Aakash Mankodi.
Mr. Bailey has been Governor, Bank of England, since 16 March 2020, on an eight year term. He was earlier Chief Executive Officer of the Financial Conduct Authority (FCA) from 1 July 2016 until taking up the role of Governor. He was earlier, Deputy Governor, Prudential Regulation and CEO of the PRA from 1 April 2013. While retaining his role as Executive Director of the Bank, Andrew joined the Financial Services Authority in April 2011 as Deputy Head of the Prudential Business Unit and Director of UK Banks and Building Societies. Previously, Mr. Bailey worked at the Bank in a number of areas, most recently as Executive Director for Banking Services and Chief Cashier, as well as Head of the Bank’s Special Resolution Unit (SRU).
The speech looked forward, based on the experience of the last few months, and from the financial crisis of 2008, “through the lens mainly of monetary policy, but bringing in financial stability where relevant, with a particular focus on central bank balance sheets”.
Drivers of central bank balance sheets
Central bank balance sheets continuously expanded since the Global Financial Crisis of 2008, in support of monetary policy and financial stability objectives. The first driver was the need to shore up high quality liquid assets of banks, which was found to be low in the crisis, and this was provided by increased demand for central bank reserves.
A second driver is the use of central bank balance sheets to provide monetary stimulus, through purchase of assets, usually government debt.
These coincided with greater use of quantitative easing. The use of central bank balance sheets proved to be more of a long term measure than originally anticipated.
Response to Covid
Such a scenario was revisited in the first big test in the post financial crisis world, when the responses to the Covid-19 pandemic saw once again an intertwining of the financial stability and monetary policy drivers of central bank balance sheet expansion. Even though the problem originated in the non-bank sector – among funds, traders and corporates – central banks injected liquidity into banks via repo operations. This played an important part in stabilising conditions, but fell short in getting liquidity to non-banks with the speed and size to the extent required, referred to as “go Big” and “go Fast” in the related paper. It raises important points about market structures, extent of self-insurance against liquidity shocks by non-banks, and nature of central bank interventions.
This has rekindled questions on how QE works, whether it is conditional on state of the economy and financial system, and to what extent it is state contingent. It has also brought central bank balance sheets to the forefront as a direct tool, and not a by-product of changes in interest rate or meeting the demand for high quality liquid reserves.
Mr. Bailey feels that QE worked effectively in the Covid crisis. It mitigated the risk of transmission of market stress to the macro-economy, avoiding a tightening of financial conditions and increase in effective interest rates.
QE normally works through signalling future central bank actions and interest rates, changing the composition of assets held by the private sector, known as ‘portfolio balance’ effects, and improving impaired market liquidity. These different channels are not mutually exclusive. But, as Bailey says, each operates to at least some extent most of the time, with all of them affecting long-term interest rates and thus economic activity and inflation.
The large QE at £200 bn, announced in March 2020, was necessary to support economic activity and ensure a sustainable return of inflation to target. The purchases were also to “be completed as soon as is operationally possible” to address the financial market dysfunction.
The paper reminds that the effect of QE can be state contingent. Consistent with that, second, the pace of QE purchases may be more important during a market dysfunction associated with a widespread shock to liquidity demand. The pace was reduced for the QE announced in June 2020, by when markets were more normal.
Implications for the future
First, a balance sheet intervention aimed solely at market functioning is likely to be more temporary, in terms of duration. Second, if QE is more powerful in crisis states, we may need to ensure enough headroom to replicate it. The determinants of QE unwind may therefore be more subtle than previously thought.
The central bank balance sheet may have more of a counter-cyclical role than the last decade would suggest. It is necessary to ensure that there is sufficient headroom for more potent expansion in central bank balance sheets when required. One measure could be the stock of assets available for purchase. It must always be possible for the central bank to purchase more assets. A constraint would arise only if the central bank is already owning a high proportion of safe assets. Such a situation could arise if negative shocks keep coming before any reversal of asset purchases happen. This may become more likely if the equilibrium real interest rate is low for a long period.
Expanding the range of assets purchased is one way to create more headroom. This happened during the Covid crisis. This partly reflected the need to ensure liquidity reaches where it is required, and the objective of directing funds to the corporate sector, supplementing banks and financial markets. This raises risk management questions for central banks. The Covid crisis, therefore, showed the need for central banks to have a wide range of tools, but some of them may be more appropriate under certain circumstances.
Conclusion
After slowing down in June, in August forward guidance was introduced, stating that there is no intention to tighten monetary policy until there is clear evidence of significant progress in eliminating spare capacity and sustainably achieving the 2% inflation target. The tools used included private sector asset purchases, longer-term liquidity provision to banks with targeted lending incentives, and direct purchasing of newly issued commercial paper to supplement market-based lending channels. It was also made clear that the tool box includes other tools, including negative rates. The tools may be state contingent in their effects, which shows the need to manage central bank balance sheets to enable such state contingency to take effect. Looking at the next decade, Mr. Bailey felt that there is need to keep options to use all tools as open as possible, and the appropriate policy mix going forward would be more nuanced than previously thought.
© G Sreekumar 2021
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