The New Normal for Central Banks
The US Federal Reserve and the European Central Bank have made clear that they intend to roll back quantitative easing by reducing their bond holdings. But the other driver of central banks’ balance-sheet expansion for the past 15 years – the provision of abundant reserves to the financial sector – remains up for debate.
LONDON – 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.