One of the most dramatic monetary interventions in recent years has been the unprecedented surge in global central bank balance sheets. This form of “money printing” has not had the inflationary effect predicted by pessimists, but there is still deep unease among some central bankers about whether these bloated balance sheets should be accepted as part of the “new normal”. There are concerns that ultra large balance sheets carry with them long term risks of inflation, and financial market distortions.
In recent weeks, there have been debates within the FOMC and the ECB Governing Council about balance sheet strategy, and it is likely that there will be important new announcements from both these central banks before the end of 2017. Meanwhile, the PBOC balance sheet has been drifting downwards because of the large scale currency intervention that has been needed to prevent a rapid devaluation in the renminbi. Only the Bank of Japan seems likely to persist with policies that will extend the balance sheet markedly further after 2017.
Globally, the persistent increase in the scale of quantitative easing is therefore likely to come to an end in 2017, and it is probable that central bank balance sheets will shrink thereafter, assuming the world economy continues to behave satisfactorily.
Investors have become accustomed to the benefits of “QE infinity” on asset prices, and are cynical about the ability and desire of central bankers ever to return their balance sheets to “normal”. They will have to adjust to a new reality fairly soon.
The Federal Reserve is the most advanced of the major central banks in its thinking on this topic. It released a statement in September 2014 that explained the likely approach to balance sheet shrinkage. Essentially, this said that shrinkage would occur only when the normalisation of interest rates was already “well under way”, and they suggested that the initial stages of the reduction would be accomplished passively and predictably, by allowing debt to run off when it matures, with little appetite for active asset sales into the bond market. This implied a slow and steady reduction in the balance sheet, with minimal shocks to markets.
Ben Bernanke, who experienced a balance sheet shock under the “taper tantrum” in 2013, has recently assessed the debate within the FOMC, and argues that the slow and steady approach should, and probably will, be maintained.
He argues that the steady state level of the balance sheet, abstracting from the needs of monetary policy, should be about $4 trillion in 2027. This is much larger than in 2007 because of the increase in the public’s demand for currency and banks’ holdings of liquid balances at the Fed under the new monetary arrangements. He implies that the FOMC should approach this path extremely gradually, perhaps over a decade.
Meanwhile, in a recently published projection, the Fed staff reckons that the balance sheet could be reduced to about $2.7 trillion by 2025, a level that would be slightly below the path implied by Bernanke. This path would reduce the balance sheet from 23 per cent of GDP to 10 per cent over 8 years.
The Fed staff’s downward path is in line with that predicted by market practitioners, assuming the economy performs well in the meantime.
Janet Yellen has not seemed to be in any great hurry to start the balance sheet shrinkage. However, several members of the FOMC (see for example John Williams and Patrick Harker) have recently indicated that they are more impatient to start the process and Congressional Republicans have repeatedly demanded a much lower balance sheet. The FOMC probably accepts that the realities of political economy mean that they will have to start the shrinkage soon.
Goldman Sachs economists believe that the FOMC will begin to reduce the balance sheet at the end of 2017, because they will want to lock in the principles of the strategy before potential new appointments to the leadership of the Fed take office next year. They assume that the Fed will allow two thirds of the maturing debt to run off in 2018, with all of the maturing debt running off in 2019.
If the Fed starts to run down its balance sheet in this more hawkish manner, it would probably mean that the total balance sheet assets of the global central banks – often known as “global QE” or “global liquidity” – will start to fall as a percentage of world GDP for the first time since the Great Financial Crisis in 2009.
In the appendix, we take the Goldman Sachs path for the Fed balance sheet, and present some assumptions about the balance sheet policies of the other major central banks to the end of 2019. Obviously, these assumptions become fairly speculative as the period progresses, because none of the central banks has made any firm statements after the end of 2017. Nevertheless, these numbers can be taken as a broad guesstimate, assuming no major change in economic performance.
The graph below shows the level of central bank balance sheets as forecast. Note that the total balance sheet is set to stabilise this year at about 35 per cent of global GDP, having risen continuously from 20 per cent before the GFC. The aggressiveness of the rise in the BoJ balance sheet under Governor Kuroda is dramatic, though the economic effects have been disappointing:
The next graph shows the 12 month change in central bank balance sheets, expressed in percentage points of global GDP. This figure has often been used as a measure of the change in the thrust of global QE from one year to another:
- The global central bank balance sheet is likely to continue rising throughout this year, though only at about 1 per cent of GDP, or roughly half the average liquidity injection since 2011;
- All of the increase in the global balance sheet in 2017 will be driven by the ECB and the BoJ, while the Fed and the PBOC might subtract small amounts;
- During 2018, the global balance sheet might shrink by about 1 per cent of GDP, because the implied shrinkage in the Fed’s balance sheet might be larger, on our assumptions, than the continuing, but falling, injections from the BoJ and ECB;
- During 2019, the rate of shrinkage of the global balance sheet might increase to about 1.3 per cent of GDP, as the Fed allows all of its maturing debt to run off, the ECB stops its QE, and the BoJ reduces bond purchases further.
I am grateful to my colleagues Alberto Donofrio and Yad Selvakumar for the following assumptions about balance sheet policy of the major central banks up to 2019:
Note: For the US, we assume that the shrinkage in the balance sheet starts early in 2018, while the latest Survey of Primary Dealers (SPD), taken in January 2017, assumed it will start in mid 2018. The start of the shrinkage requires that the increase in the Fed Funds rate is “well under way” by then. At the time that the shrinkage starts, we assume that the Fed Funds rate will be 1.38 per cent, while the SPF also assumes the same Funds rate of 1.38 per cent. Therefore, the difference is that we assume that the Funds rate reaches the required rate for the new policy to start earlier than was assumed in the latest SPD. Janet Yellen has said there is no magic level of the Funds rate required to press the exit button, but other FOMC members have talked about a required rate of around 1.0-1.5 per cent.
This post originally appeared on Financial Times