Some Sound Advice From the BIS

The Bank for International Settlements is not only a provider of financial services to central banks and the home of the Basel Committee on Banking Supervision, it is also a think tank on central banking. On Sunday, June 25, 2023, it just released its Annual Report. The chapter on monetary and fiscal policy concludes with the following advice for central banks:

Careful consideration should also be given to keeping central bank balance sheets as small and as riskless as possible, subject to delivering successfully on the mandate. This would have three benefits. First, it would limit the footprint of the central bank in the economy, thereby reducing the institution’s involvement in resource allocation and the risk of inhibiting market functioning. Second, it would lessen the economic and political economy problems linked to transfers to the government. Finally, it would maximise the central bank’s ability to expand the balance sheet when the need does arise. Given the costs of large and risky balance sheets, the initial size is a hindrance, not an advantage. The balance sheet needs to be elastic, not large.  p. 69

The advice seems to be aimed at least in part at the Federal Reserve. Before the Global Financial Crisis, at the end of June 2007, the Fed’s balance sheet was 6 percent of U.S. GDP. Now it is 32 percent. It owned $800 billion in Treasury securities then; now it owns over $5 trillion in Treasury securities and $2.5 trillion in mortgage-backed securities. It conducted monetary policy by engaging in relatively small ($20 billion) repo operations with a handful of primary dealers.  Now it conducts daily reverse repos for $2 trillion with hundreds of money market mutual funds, GSEs and foreign official institutions. Its operations resulted in banks holding $16 billion in reserve balances (loans to the Fed); that number is now $3.2 trillion.[1]

When the BIS says a “riskless” balance sheet, it is referring to interest rate risk, and when it says “political economy problems linked to transfers to the government” it means losing huge amounts of taxpayers’ money. As noted elsewhere in the report:

The balance sheets of the central bank and the government are joined at the hip. This, in turn, tightens the link between monetary and fiscal policy and can blur the distinction between them. The balance sheets are intertwined because the central bank is “owned” by the government or is part of it, sending to it remittances based on the institution’s financial results.

Because of the massive, unhedged interest rate risk the Fed took, it has been losing money since September 2022 and is now losing about $2.7 billion a week.[2] Moreover, the Fed has the financial advantage of being funded in large part by currency, on which it pays no interest. If the Fed had simply issued currency and invested in Treasury bills, it would be earning $2.3 billion a week, money that would be handed over to taxpayers to pay for expenditures or reduce the debt. So on net, considering opportunity costs, the Fed is losing taxpayers $5 billion a week.

How did we get here? Most recently, after massive, necessary asset purchases to stabilize financial markets in March and April 2020, the Fed unnecessarily bought another $3 trillion in longer-term securities over two years through March 2022, at which point the employment gains were strong and inflation was elevated. To use the BIS’s words, the purchases were by no means necessary for “delivering successfully on the mandate.”

More subtly, we got here because the bigger the Fed becomes, the bigger it has to be. As Claudio Borio, the head of the think tank arm of the BIS, recently observed:

In addition, there is a risk of a ratchet effect: the longer the [abundant reserve system] stays in place, the greater the demand for reserves can become. Variants of such concerns have led the Central Bank of Norway and the Swiss National Bank to take half a step back and adopt tiered floor systems and absorb reserves.

Moreover, the Fed had to expand its footprint because it had become so large that the banking system alone could no longer fund it through reserve balances without interest rates going negative, especially because the Fed requires banks (but not money funds) to fund their loans to it in part with capital.

Sadly, not that long ago, the Fed would not have needed the BIS’s advice on how to manage its balance sheet. In 2002, the Federal Reserve System published a study “Alternative Instruments for Open Market Operations and Discount Window Operations,” in which it examined what assets it could hold to replace Treasury securities, because the federal government was running surpluses and debt was expected to decline to zero.

One of the four principles articulated in the study was “…minimizing relative price effects and credit allocation in the private sector…”. It adopted that principle because “…market price mechanisms allocate resources most effectively when undistorted by government actions, and market-directed resource allocation fosters long-run economic growth.”[3] For example, investments in agency debt and agency MBS were seen as undesirable because “Such a strategy could tend to affect credit allocation and relative prices; also, large Federal Reserve holdings might reinforce the misconception that the government would not allow these issues to default.”[4]

Regarding interest rate risk, the study observed that the FOMC’s “…desire for a short-term portfolio has skewed the System’s holdings away from long-term securities whose values fluctuate the most with changes in interest rates.” It concluded that:

The implications of bearing greater interest rate risk are similar to those for bearing credit risk. The level of interest rate risk should be well managed and compatible with what is necessary to meet the objectives of monetary policy.

While noting that there might be times when it was necessary to take on interest rate risk, in particular if the federal funds rate was at the zero lower bound, the study observed that “[i]n taking on portfolio risk for policy purposes under these circumstances, the Federal Reserve would likely be in close communication with other governmental entities, including the Treasury and the Congress.”[5]

[1] The one thing that hasn’t changed is the Fed’s holding of Treasury bills. It was $277 billion, now its $273 billion.

[2] How is the Fed paying for its operations (and the operations of the CFPB)?  It’s borrowing from banks, money market mutual funds, GSEs and foreign official institutions. To date, it has borrowed $72 billion from these entities to cover its expenses.

[3] Page 1-2.

[4] Page 1-12.

[5] Pages 1-7 to 1-8.