MNI INTERVIEW2: Ample Fed Reserves Need Tighter Rules-Acharya

Ballooning central bank balance sheets have also fueled a jump in financial liabilities that create new stability challenges – as evidenced by the Fed’s need to support the banking system last year as it advanced QT, ex-New York Fed resident scholar and Reserve Bank of India deputy Viral Acharya told MNI.

“In the middle of QT you back-stopped all uninsured depositors, and so you say QT is working fine. In the middle of QT, the Bank of England did a complete somersault and went from withdrawing to injecting and then you say everything is fine,” Acharya said in an interview.

“You really have to take the full sum total of all your various policies as a whole because they’re all interacting with each other," he said.

While Fed officials appear set on maintaining the ample reserves regime that requires a much-expanded balance sheet, Acharya said that requires an even better grip over financial stability than a scarce reserves regime where market forces are more active in setting the right level of reserves.

“You have to be sure at every step of your central bank balance sheet policy, that the macro prudential regulation is ensuring that there aren't vulnerabilities of the type that we saw last year. And as of now, we have just patched up the banking system. It's not clear that we have fundamentally dealt with those vulnerabilities," Acharya said.

In March of last year, regional banks led by Silicon Valley Bank ran into trouble because of their large exposure to Treasury securities that fell sharply in value after the Federal Reserve’s interest-rate hikes starting in March 2022. Authorities intervened and the Fed launched a new emergency lending facility to stabilize the banking system.

MINDFUL OF VULNERABILITIES

“It seems unlikely that many central banks have the appetite to go back to a scarce reserve system. If you don't want to do that, then you better have a complete grip on the financial stability of the banking system and perhaps even the non-bank system because you have created a lot of short-run liabilities,” Acharya said. (See MNI INTERVIEW: Riksbank QT Boost Bond Market-Debt Head)

Fed officials have said they will discuss when to begin reducing the pace of runoffs at their March meeting.

Central banks embarked on large-scale asset purchases, or QE, in response to the global financial crisis of 2007-2009, and then again during Covid. But Acharya said they undertook those policies without much consideration to the effects on financial stability.

“If your central bank balance sheet size is making financial conditions very easy, that would raise the leverage and deposit taking in the system, that might lead to greater financial risks down the line,” he said.

“They should be looking at sources of fragility in the commercial bank balance sheets are in financial sector balance sheets more generally.” (See MNI INTERVIEW: Active QT Can Aid Hikes Without Market Turmoil)