MNI INTERVIEW: Big Central Bank Balance Sheets Here To Stay

Central banks will inevitably end up with very large balance sheets by historical standards despite efforts to sell assets accumulated through quantitative easing because of the demand for reserves from commercial banks, economics professor Stephen Cecchetti, a former head of the Monetary and Economic Department at the Bank for International Settlements, told MNI.

With the Bank of England, the Federal Reserve and others offering enhanced facilities to supply banks with reserves, partly in order to avoid driving short-term money market rates markedly higher than policy rates, balance sheet size will be demand-led, Cecchetti, now a professor at Brandeis International Business School and senior research consultant at King's College Business School, said in an interview.

"We know that the banking system's desire for reserves is very large indeed and ... irrespective of whether they categorise or sell-off the gilt holdings, the asset holdings they built up during QE ... you're going to end up seeing a pretty large central bank balance sheet," he said, adding that targeting a particular level of reserves would make no sense.

SURVEYS UNDERSTATE DEMAND

While some 25 years ago the Fed's total reserve levels were around USD10 billion, Cecchetti said he would be “shocked” if it now managed to reduce bank reserves below USD2 trillion. A similar situation exists on this side of the Atlantic, he said. (See MNI INTERVIEW: RRP Drop Creates Headroom for Fed QT To Run)

“We could rescale for the UK banking system and the UK economy and my guess is you're going to see something quite similar. The banks are going to just want reserves," he said.

The BOE's last published survey of sterling money market participants showed a range for desired reserve holdings of GBP325 to GBP480 billion, which would only halve the size of the balance sheet from levels at the start of 2022. An update on the bank's thinking on future balance sheet size looks due, with BOE markets head Andrew Hauser set to speak Friday.

Cecchetti, who noted that central bank surveys have in the past underestimated demand for reserves and could do so again, said that the focus on the size of their balance sheets is overblown. Central banks are not banks in any normal sense, in his view, but rather arms of the state with tools to set monetary policy, act as lenders and market makers of last resort, provide selective credit and ensure emergency government financing.

DEMAND-DRIVEN

"I don’t think the size of the central bank's balance sheet has much to do with anything in terms of macroeconomic phenomena, like growth and inflation. It has to do with financial stability considerations and so on," Cecchetti said. "So let's just make sure that we meet those objectives. And I think that's what they're going to be pushed into doing. And I think that that means that it's going to be demand-determined and … whether or not the central bankers like it is a whole different issue.”

Current BOE head Andrew Bailey has advocated shrinking the balance sheet in order to free up firepower to deal with any future shock but Cecchetti was dismissive.

“It was a very strange argument. It reminds me of an argument that people were making at one point … that they raise might want to raise interest rates because they might want to lower them later ... the size of the central bank balance sheet is arbitrary, because the central bank can always make it bigger if it wants, regardless of its current size," he said.