2.1Understanding Relevance of Central Bank Balance Sheet in Functions of Economy

The analysis of the central bank balance sheet is important in designing and understanding the policies needed to support an economic recovery in post-financial crisis years. This book asserts that a deeper comprehension of changes to the central bank balance sheet can lead to more effective policymaking. We support this assertion by highlighting the challenges and controversies faced by central banks in the past and present when implementing policies, and analyze the links between these policies, the central bank balance sheet, and the consequences to economies as a whole.

Every country has a central bank with specific features in terms of name, organizational structure, monetary policy targets, ownership, and level of autonomy. Some countries like Nigeria, name their central bank by adding the country name to the phrase “Central Bank of” while other such as the United Kingdom and Ghana attach the phrase “Bank of” to their country name (Bank of England, Bank of Ghana). Countries such as the United States and South Africa adopt the use of “Federal Reserve.”

Most central banks have institutionalized inflation targeting. Recently, about seventy economies were regarded as inflation targeting countries. The creation of money has been considered a common feature of central banks in the world and their establishment was legally backed up.

Before the book delves deeper into its main theme, it is essential to provide readers with the fundamental information required to comprehend the content of this book. Therefore, the next subsection will be dedicated to that purpose, but this may be skipped by those readers who have a basic understanding of the balance sheet.

2.1.1Similarities and Differences between a Company’s Balance Sheet and a Central Bank Balance Sheet

A balance sheet of any organization provides information on financial status at a specific point in time. This implies that balance sheets can be created weekly, monthly, quarterly or annually. The balance sheet also provides an insight into an entity’s fiscal health, enabling stakeholders to assess previous performance and predict future trends.

However, different types of entities such as corporations and banks explore different types of information on their respective balance sheets. This creates many differences between a central bank’s balance sheet (see Figure 2.1) and a corporation’s balance sheet. These differences are as follows:

1. A central bank’s balance sheet is prepared in line with the established guideline whereas a company’s balance sheet is prepared in relation to the regulation of the International Accounting Standards Board (IASB).
2. The main objective of the central bank balance sheet is to ensure a stable financial system, while a company’s key objective is to present the accurate financial position of an organization to the stakeholders.
3. The scope of a central bank’s balance sheet covers the financial system of the whole economy whereas the counterpart’s scope is applicable for all sorts of companies.
4. A central bank’s assets and liabilities are very different from any regular company.
5. The economic situation influences the composition of the central bank’s balance sheet; however, this is insignificant in a company’s balance sheet.

At the onset, governments set up central banks with the aim of creating reliable payment systems. Over time, the central bank’s responsibility increased to managing entire financial systems and economies. Their key method has been to influence the cost of money through a change in interest rates. This was initially applied in an effort to boost or slow the economy, and then as a means of ensuring stability.

Any transaction engaged in by the central bank—for example, issuing currency, conducting foreign exchange operations, investing its own funds, intervening to provide emergency liquidity assistance, and carrying out monetary policy operations—influences its balance sheet. Despite the relevance of the balance sheet, many central banks have largely ignored balance sheet movements, such as assets and liabilities and instead have focused on implementing price targets—establishing targets for a price index like the consumer price index. In addition, economists generally do not favor analyzing balance sheets for patterns that could inform policy decisions. However, analysis of the composition and evolution of the central bank balance sheet provides a valuable basis for understanding the needs of an economy, and is an important tool in developing strategies that would most effectively achieve policy goals.

The fundamental aim of this book is to provide a sound framework for comprehending a central bank’s balance sheet. The importance of the central bank’s balance sheet also extends to its main liabilities in the functions of the economy. The strength (or weakness) of a central bank’s balance sheet provides the trust (or lack thereof) that supports or undermines the legitimacy of most forms of money circulating in an economy.

Monetary policy can be defined as actions of central banks, which affect the size and rate of money supply growth in an economy. Its instruments for implementing these actions include interest rates, forward guidance, large scale asset purchases (QE), and additional liquidity operations such as repurchase agreements. Setting an interest rate would directly influence cost of borrowing, thus affecting economic conditions—lower borrowing cost would stimulate economic growth and vice versa.

Price level targeting is a monetary policy framework designed to ensure price stability. It establishes targets for a price index like the consumer price index. As inflation targeting is forward looking, the price-level targeting is applied to correct any short-term deviations from the target rate of inflation. For instance, in the latter half of the twentieth century, Peru experienced a long inflationary challenge. This led to the International Monetary Fund (IMF) imposition of austerity policies on the country. Its economy suffered stagflation at that time, and gave Alan Garcia the opportunity to become president in 1985. Alan’s economic reforms weakened the economy and drove Peru out of global credit markets. This condition hindered access to credit, and worsened the economic situation, and transformed high inflation into hyperinflation in Peru (http://www.businessin-sider.com/worst-hyperinflation-episodes-in-history-2013-9?IR=T#china-october-1947-may-1949-6). Deflation in the Eurozone occurred when European prices declined and imports of European goods became cheaper. This made imports into Europe more expensive and pushed inflation up in Europe.

2.2Trajectory Relevance of the Central Bank Balance Sheet

The lack of attention paid to central bank balance sheets can be attributed to the actions of central banks in moving away from quantitative targets such as money targets and moving toward price targets like inflation, using exchange rates as a means of guiding monetary policy. In the late 1970s and early 1980s, central banks used narrow measures of money supply as an operational target, thus leading to a greater focus on the central bank’s balance sheet. The status of the reserves balance, as reported on the central bank’s balance sheet, was of great interest to both practitioners and observers. Figure 2.2 indicates a long-run interest rate for G7 economies. As shown in the figure, G7 real interest rates move closely to the convergence point in recent years. Since the early 1960s, the trend patterns were characterized by three episodes. The first episode was a decline in the interest rate up to the mid-1970s; followed by the second episode of a rise until the late 1980s, and then the third episode recorded a fall since the late 1980s.

However, many central banks abandoned quantitative targets such as a money target because of their relatively poor performance in guiding sound policy. The failures of this policy framework were associated with two factors. First, the central bank has limited influence on the size of its liabilities in the short run. Demand for both banknotes and reserves is exogenous in the very short term, and any attempt to influence in the form of short-term liabilities would result in considerable market instability. Second, there is no clear justification for the central bank to control the quantity of its liabilities.

The money multiplier is closely related to the ratios of commercial bank money to central bank money under fractional-reserve banking. The money multiplier is used to measure the maximum amount of commercial bank money that can be created, given a certain amount of central bank money. Money supply can take the form of narrow and broad money. Narrow money is a type of money supply that includes all physical money such as coins and currency, demand deposits, and other liquid assets held by the central bank. Broad money is defined as the sum of assets that can be used to make payments or held as short-term investments such as currency, funds in bank accounts, and anything of value resembling money.

Key explanations mainly focused on the concept of the money multiplier, which both oversimplifies the importance of commercial banks in money creation and wrongly specifies the causality between narrow and broad monetary aggregates. Without the money multiplier, targeting the quantity of money has no sufficient theoretical justification for a central bank. The money multiplier captures the amount of money banks generate given a certain amount of central bank money. Countries such as Canada, the UK, Australia and Sweden set no legal reserve requirements, compared to those countries such as USA where the reserve requirement is expressed as a ratio of deposits held.

The abandonment of quantitative targets in the late 1980s and early 1990s led many central banks to use either an explicit inflation target as their monetary policy framework or a closely related framework.

These frameworks explore a short-term interbank rate as the operational target of monetary policy, implying that central banks focus on the local price of money and the ways in which the local price of money affects the ultimate objective: inflation. Small open economies, as well as large commodity exporting countries, choose an exchange rate target as their monetary policy target with the purpose of providing a better nominal anchor. Under such a framework, the operations of money markets are implemented to enhance the exchange rate or the external price of money. Proponents of both frameworks believe that the quantity of money does not influence the short-term price level, but does allow commercial banks to access central bank liabilities that are important in attaining the targeted price (the target for the consumer price index).

The renewed interest in the central bank balance sheets has arisen because of the 2007–2008 financial crisis. Responses to the crisis, which were often unconventional in nature, fueled significant increases in the size of central bank balance sheets.

Worldwide, there were substantial disparities in the actions taken by economic authorities during the initial stages of the financial crisis. Many economies halted their participation in interbank markets in order to smooth the dissemination of reserve balances among commercial banks. This caused many commercial banks to hoard reserves instead of lending in interbank markets, partly as a means of safeguarding them against potential negative shocks, and partly to heighten credit risk fears in the potential start-up banks. A slowdown in fund dissemination experienced by interbank markets hindered the ability of commercial banks to settle transactions in commercial bank deposits. In response to the crisis, central banks explored various measures to increase the supply of reserves in order to ensure the smooth settlement of transactions. This response is viewed as liability-driven. By attaining their effective lower bounds of desired prices, central banks readjusted to broaden policies designed to boost economic growth. Desired prices are set to include lower and upper bounds. As the lower bound is attained, the central banks can decide how to reach the upper bound in order to further boost economic performance. These approaches are common to those central banks that adopt band targets rather than a point target. A band target has a range while a point target does not. Consequently, many central banks implemented asset-buying policies to lower longer-term interest rates (both lowering risk-free rates and the spread between risk-free rates and other rates), and affect the portfolio composition of agents in the economy.

The creation of reserves was used to finance the purchase of assets. This led to continual rises in the size of central bank balance sheets, and thus resulted in asset-driven growth.

Exchange rate targeting economies were confronted with the effects of the global financial crisis through additional channels. The fluctuations in global capital flows dramatically affected the exchange rates of many currencies. At the apex of the crisis, emerging economies experienced varying degrees of capital flight as investors sought safe havens for their currency. This resulted in the depreciation of many developing economy currencies, thus forcing monetary authorities (central banks) to intervene and protect the value of their currency. As financial markets witnessed improving conditions, the amount of liquidity increased. Improving liquidity conditions were partly supported by the success of unconventional policies (including the use of asset purchasing measures based on the central bank balance sheet) adopted by many advanced economies. Eventually, this led to the resumption of capital flows into emerging economies and triggered central banks to respond to appreciation pressure. This timeline of events renewed interest in the size and composition of the central bank’s balance sheet.

The Great Depression of the 1930s was the aftermath of the failure of major central banks to address fully the consequences of debt deflation. Central banks failed to utilize their balance sheets to sufficiently reduce long-term rates (as discussed above) and counter a cascading sequence of bankruptcies. The policymaking failures during the Great Depression served as a cautionary lesson for monetary authorities in responding to the 2007/2008 financial crisis.

It is historically proven that central banks allowed balance sheets to expand excessively, with the aim of financing profligate government spending. This led to high inflation; however, central banks were reluctant to tighten monetary policy when conditions improved.

The Asian financial crisis of 1997–1998 convinced monetary authorities that building up foreign exchange reserves would safeguard against future crises, or perhaps mitigate the effects of a financial downturn. This led to a huge rise in forex reserves held by central banks in emerging Asian economies—from $2 trillion at the beginning of 2006 to more than $5 trillion today—proportionally equivalent to 45 percent of emerging Asian economy gross domestic product (GDP). Rising foreign exchange reserves also reflected the exchange rate targeting regimes and export-oriented growth measures implemented by many countries. The effectiveness of this measure translates into the greater economic performance experienced in many emerging Asian countries. As illustrated in Figure 2.3, the Fed commenced purchasing longer-term Treasury securities as well as the debt and the mortgage-backed securities (MBS) in December 2008. About US$75 billion of longer-term Treasuries was intended to be purchased by the Fed on a monthly basis in November 2010. This amount increased to nearly US$85 million per month in September 2012 under QE3. During this period, the Fed decided to continue the purchase of securities to the point where there was sufficient improvement in the labor market.

Figure 2.4 presents the cumulative change in central bank balance sheets since August 2008. All central banks excluding the Reserve Bank of Australia witnessed a positive cumulative change in the related period. However, the Reserve Bank of Australia continued to record a negative cumulative change in its balance sheets since August 2009.

2.3Externality of the Central Bank Balance Sheet Size

The global financial crisis of 2007–2008 triggered the zeal of central banks to buy “unconventional” assets on a large scale such as purchases of long-term government bonds, particularly in advanced economies. Central banks started by purchasing short-term assets and engaging in short-term lending, but gradually moved toward purchasing long-term paper. The total size of central bank balance sheets in advanced economies was about US$20 trillion in 2017, the equivalent of more than 20 percent of global GDP. Lower, zero-bound interest rates meant little room to maneuver through traditional means, so monetary policy was directed toward large-scale asset buying programs (such as TARP in the United States) as a fundamental tool to prevent any renewed financial meltdown that may have been caused by a severe credit crunch. These policies generated an additional monetary stimulus through reducing the long-term interest rate on government bonds, even with short-term interest rates near zero.

A negative aspect of sustained expansions in their balance sheets is that central banks become increasingly exposed to market fluctuations. For instance, a fall in the value of foreign assets or a rise in long-term interest rates could decrease the value of their assets, while the value of their liabilities remains unchanged. This would put the capital of the central bank at risk and may even undermine the central bank’s credibility, perhaps leading to greater market instabilities and panic.

Thus, central bank policies that increase the size of a central bank’s balance sheet have the ability to generate broader policy risks such as inflation, financial instability, distortions in financial markets, and conflicts with government debt managers.

Exploring balance sheet-related risk is a useful guide in designing suitable exit strategies from monetary policy positions such as asset-purchasing programs, and addresses the following sets of questions:

The following chapters in this book will explore the answers to the questions above, and aid in developing our understanding of central banking and the impact of balance sheet changes on the economy as a whole.

Questions