When our first child arrived, we knew the first months would be chaotic. Once the baby’s cycle stabilized, we told ourselves, we’d be able to get back to normal. Well, it took longer than we thought; more than 25 years. But we’re finally close to returning to our pre-child equilibrium.
Business cycles were disrupted by the chaos of 2008. To respond, central banks have extended themselves in an effort to reach a more settled equilibrium. Conventional wisdom was that central banks would eventually return to normal by unwinding these extraordinary measures. Yet some scholars are recommending a new approach to monetary strategy that keeps balance sheets much larger for much longer. This approach, however, comes with significant financial and political risks, and its efficacy is far from clear. Before central banks lock up assets and throw away the key, they should reflect very carefully on potential consequences.
Monetary authorities in the developed world have added significantly to their balance sheets in the last decade through quantitative easing (QE) programs of various sizes and styles. The U.S. Federal Reserve ceased new asset purchases almost two years ago, but the Bank of Japan (BoJ), the Bank of England and the European Central Bank (ECB) are all still expanding their QE efforts.
Committing to a QE program is essential to shaping market psychology. If investors anticipate that the effort is transitory, it won’t have the desired effect. Nonetheless, the widespread belief has been that central bank balance sheets would eventually recede to pre-crisis levels. In her keynote remarks at this year’s annual Jackson Hole Economic Policy Symposium, Fed Chair Janet Yellen reiterated the Fed’s intent to follow this course.
But during a subsequent panel in the symposium, Jeremy Stein, a former membfer of the Board of Governors of the Federal Reserve System, proposed an alternative strategy. He suggested central banks should keep large balance sheets long after interest rates have moved away from zero. Stein argued that such a policy could curb the tendency of financial companies to fund short and lend long, a strategy that leaves them (and the financial system) vulnerable to liquidity and interest-rate risk.
Ben Bernanke, who attended the Jackson Hole symposium for the first time since leaving the Fed, seemed to endorse the maintenance of large balance sheets in a recent blog. Bernanke notes that high levels of excess reserves held by banks have changed the dynamic of managing interest rates at both the short and the long ends of the yield curve. Keeping the balance sheet large, he argues, could improve the transmission of monetary policy to the broad economy.
There are, however, several reasons why central banks should be very cautious about turning unconventional policy into business as usual.
First, it seems that central banks are extending themselves into areas that had been the province of private-sector financial institutions. They have become primary creditors by investing in non-sovereign debt, and some have become investors by extending into equity markets. The BoJ, for instance, holds more than half the total volume of Japan’s outstanding exchange traded funds (ETFs).
Central bank balance sheets typically have short-term funding, but most have lengthened the maturity of their assets significantly over the past decade. The printing press is the ultimate safeguard against the risk presented by this mismatch, but using it might ease credit just as policy should become more restrictive.
New capital and liquidity requirements have reduced the level of credit extension and maturity transformation among private-sector financial firms. As central banks move to take up some of the slack, their balance sheets are exposed to heightened levels of credit, market and (in some cases) currency risk. It is not clear that central banks have the infrastructure to measure or manage these risks to the same standard that regulators require from private-sector firms.
Losses taken on those positions can be rationalized (hopefully) by the better economic outcomes that often result from quantitative easing. But losses invite additional political scrutiny, which could ultimately erode central bank independence. The choice of which assets to buy may favor some sectors or countries over others, which might bring the central bank additional criticism.