MNI POLICY: Larger Balance Sheet Comes With Costs -Paper

By Jean Yung

     WASHINGTON (MNI) - The expectation that a central bank will maintain a

large balance sheet after concluding a period of extraordinarily easy monetary

policy could result in a deeper recession, according to new research into the

potential costs of quantitative easing to be presented to the FOMC on Wednesday.

     Notre Dame economists Eric Sims and Cynthia Wu find that plans for balance

sheet normalization can impact how the economy fares during a period at which

interest rates are near zero. Specifically, a smooth balance sheet normalization

is preferable to immediate normalization or to carrying a significantly larger

balance sheet going forward. 

     "Carrying a large balance sheet forward would cause a deeper recession and

force the central bank to expand their balance sheet even more at the peak,"

they found.  

     A larger balance sheet also undermines the effectiveness of negative

interest rates, they found. In their model, increasing the size of the central

bank's steady state balance sheet to 38% of GDP, roughly that of the Euro area

as of the end of 2018, causes negative interest rate policy to become actually

mildly contractionary. 

     What's more, the "effective lower bound" for interest rates could be "quite

close to zero" if the central bank carries a larger balance sheet, constraining

the potential to take rates to more deeply negative levels, they said. The

effective lower bound is the threshold below which financial intermediaries

would voluntarily choose to exit the market. 

     "In spite of its usefulness, QE does not come without cost," the authors

wrote. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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