The new normal for central banks as balance sheets set to get smaller

Central banks have drastically changed the way they implement monetary policy. Since the 2008 global financial crisis, the US Federal Reserve and the European Central Bank have been providing liquidity directly to banks and other financial institutions – an activity that used to be the preserve of money markets – and massively expanding their balance sheets. Is it time to reverse these changes, reviving interbank money markets and shrinking central-bank balance sheets, or is this the new normal?

To be sure, central-bank balance sheets are already set to get somewhat smaller. The Fed and the ECB have made clear that they intend to roll back quantitative easing by gradually reducing their bond holdings. But the other cause of central banks’ balance-sheet expansion – the provision of abundant reserves to the financial sector – remains up for debate. Though the Fed has formally adopted this approach as its new operational framework, the ECB has launched a review of the policy.

The fundamental question that must be answered is whether the benefits – that is, the added financial stability – warrant the risks. Here, the first thing to consider is why central banks started providing reserves to banks in the first place. During the 2008 crisis, trust in financial institutions’ creditworthiness collapsed, and the threat of contagion caused interbank money markets to freeze, forcing central banks to step in. By providing liquidity directly to each market participant, monetary authorities effectively substituted their balance sheets for the money market.

But there had to be a division between this new activity and the implementation of traditional monetary policy. Both the Fed and the ECB solved this problem in the same way: by paying interest on reserves. Rather than using market operations to increase or reduce the volume of reserves in the banking system, thereby steering its target interest rate, the central banks used the interest rate on reserve balances to steer the effective overnight rate. This enabled them to provide reserves to the point of satiation for financial-stability purposes, while continuing to guide short-term interest rates for monetary-policy purposes.

Not surprisingly, this “ample reserves” approach caused central-bank balance sheets to balloon. It is also worth noting that, under this system, the size of the central bank’s balance sheet depends on market demand for liquidity, which has proved to be both variable and unpredictable.

Some now say that enough is enough. The post-crisis monetary-policy regime, they say, was a justified response to a generalised credit crunch, but that it is not suited for normal times. Sustaining it is leading to the death of interbank money markets – which did have a valuable role to play in the economy – and causing banks to become dependent on central-bank liquidity.

But these risks might be overstated. Central banks can, after all, offer liquidity at zero cost. Evidence suggests that strong demand for central-bank reserves is a new structural feature of a market in which financial institutions have a strong preference for safety, and regulations that made them safer also made it very costly for them to hold less liquid assets. Why risk creating liquidity problems by abandoning a framework that has proved so robust?

- Project Syndicate