Central Bank Balance Sheets: What Is “Normal”?
In a post quantitative-easing (QE) world, central bank balance sheets in many countries have expanded to extreme levels, with little hope of their size shrinking back to levels that prevailed before the financial crisis. Many commentators have despaired that central banks’ balance sheets will never return to normal levels again – but what do we mean by “normal”?
- The U.S. Federal Reserve’s (Fed) balance sheet exploded with the commencement of quantitative easing (QE). The expansion broke the balance between supply and demand for funds in the market, creating the excess liquidity conditions that drove significant asset price inflation.
- The spike in funding costs in the U.S. money markets over the last week, due to a shortage of reserves, has spooked the markets. However, there have been warning signs for some time that reserve scarcity was starting to pick up.
- This is not a systemic flaw that will propagate a funding crisis – the Fed has all the tools to resolve the problem. However, it might mean that the Fed’s balance sheet will need to start increasing again, albeit gradually.
Last month, I wrote that the end of the U.S. Federal Reserve’s (Fed) balance sheet withdrawal process marked the death knell for any chance of a return to the normal level of central banks’ balance sheets seen pre-Global Financial Crisis and pre-QE. While true on some level, that statement missed a rather important point by failing to raise the question: “What is normal?”
According to data from the Center for Disease Control and the Department of Agriculture, the height of the average man in the U.S. increased by one inch between 1960 and 2002, while his weight went from 166 pounds to 191 pounds. Though we can only speculate, it seems fair to suggest that an American male from the ‘60s might have a different view on what a “normal” waist size would be relative to his present-day contemporary. The point is not a reflection on modern-day trends in American dietary habits but rather serves to illustrate that normal can only be assessed in context.
Balance Sheet Inflation
In the pre-QE, pre-Crisis era, the Fed – and, more specifically, its rate-setting body, the Federal Open Market Committee (FOMC) – specified a target lending rate for the federal funds market and then mandated that the New York Fed conduct open market operations. The goal was to buy and sell U.S. Treasuries with their bank counterparties to ensure a sufficient level of reserves in the system such that the supply and demand for funds balanced at the Fed’s target rate.
Over time, the Fed’s balance sheet has expanded gradually, reflecting primarily the increase in demand for currency in circulation, which naturally occurs as the economy expands. As shown in the chart below, this gradual increase continued until 2008. In the second half of 2008, however, things abruptly stopped being normal as the Fed’s balance sheet exploded with the commencement of QE.
The Fed’s Balance Sheet: Reserves Went from Plentiful to “Gargantuan” Starting in 2008
The New Normal for Reserves
With the dawn of zero rates and quantitative easing, the Fed’s balance sheet expanded dramatically, in turn breaking the balance between the supply and demand for funds in the market. This balance tilted firmly in favor of supply, creating the excess liquidity conditions that drove significant asset price inflation that saw the S&P 500® Index more than quadruple from its 2009 low to the present day.
The excess liquidity also had the effect of causing interbank funding rates to drop to almost nothing (the Fed targeted a range for lending rates of 0%-0.25%) as the glut of reserves resulted in a marginal value of zero to this excess liquidity. At this point, there was much handwringing by economists over the imminent inflationary storm that was coming our way, as these excess reserves would inevitably flow into the real economy, lifting prices.
So, looking at the chart, it seems reasonable to say that starting in late 2008, reserves went from being “plentiful” to a “gargantuan oversupply.” What’s more, the Fed’s balance sheet shrinkage between 2018 and August 2019 seems only to have made a slight dent in reducing the oversupply of reserves to the system – hence the comment that any hope of seeing a return to the normal level of central bank balance sheets seems to have died in August.
Yet over the past week, the bond markets have been awash in commentary about spiking funding costs in the U.S., driven by a shortage in reserves. What gives?
As with the ’60s view of today’s horizontally challenged average man, the context of the central bank balance sheet matters. Since the financial crisis, significant changes to bank regulation and, in particular, the introduction of the Liquidity Coverage Ratio (LCR)1, have resulted in a significant pickup in demand for certain assets, specifically high-quality liquid assets (those with a high potential to be converted easily and quickly into cash; HQLA in regulatory parlance), and even more specifically, central bank reserves (a particularly high-powered HQLA).
Subsequently, while to the layperson a “normal” level of reserves might involve extrapolating the gently rising line that was in place pre-2008, the reality has been that a much higher level of reserves is now required to balance the supply and demand for funds in the market. More importantly, it has been very hard to pinpoint ahead of time just what this level should be due to the discretionary nature of the makeup of central bank reserves within banks’ HQLA.
Pin the Tail on the Donkey
For all intents and purposes, the Fed’s approach to “normalizing” the state of its balance sheet has been like a game of pin the tail on the donkey, with the Fed trying to maintain an ample level of reserves to maintain balance in the system, all while not being able to observe at what level of reserves this ceases to be the case except by the markets’ output.
The Fed’s stated aim has been to try and maintain a reasonable excess of reserves in the market and then use special facilities developed in the post-Crisis era to marshal the market-derived funding rates within the targeted range set by the FOMC at each of its meetings.
Until recently, the Fed was fairly sure it was managing to do exactly that. However, the recent funding shock in markets, which saw certain overnight borrowing rates hit close to 10% and caused the effective fed funds rate to move above the top level of the Fed’s targeted range for the first time since 2008, has rather blown that theory away.
While to some (including the Fed) this seems to have come out of the blue, there have been warning signs in the money markets for some time that reserve scarcity was beginning to pick up. Market funding rates have repeatedly drifted higher over the past 18 months or so. In response, the FOMC has thrice moved down the interest rate it pays on excess reserves posted at the Fed to maintain market funding rates in the appropriate range (the IOER – interest rate on excess reserves rate – is one of the special facilities developed in 2008).
Warning signs have been cropping up in funding markets for some time, but the tweaks to the IOER have managed to contain the stresses and strains from inhibiting the desired policy transmission the Fed is looking to set. However, rather like a sailor steering a dinghy too close to shore, the Fed has been lifting the center board each time the boat begins to ground on the seabed. While each time this allows the boat to sail a little closer without issue, eventually the boat will be wrecked, either running aground or hitting a submerged rock. This week, the funding markets hit that proverbial submerged rock as a confluence of events resulted in a sudden drop of liquidity in the system and a spike in the cost of overnight funds.
What does all this mean and why does it matter? Importantly, this is not some systemic flaw that will propagate a funding crisis. The Fed has all the tools and abilities to resolve the problem. In fact, it has conducted repurchase operations over the past few days to inject more funding into markets, which has soothed, if not solved, the problem.
The net effect of these repurchase operations has been to increase the asset side of the Fed’s balance sheet and increase the amount of liquidity in the system. Indeed, the solution to the recent funding problems will be that the Fed’s balance sheet will likely need to start increasing again, albeit gradually.
For those who saw the exponential increase in central bank balance sheets in the post-Crisis era as an abomination, the good news is that monetary policy has been far less accommodative as of late than many of the inflation mongers had feared. For those less prone to extremes of emotion around central bank policy, it appears the good news is that normality seems to have already returned. But then again, without context, what is “normal” anyway?
The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions to ensure their ongoing ability to meet short-term obligations.