It is the adoption of modern accounting standards for central banks that perhaps best summarizes the tension between a central bank’s actual abilities and the institutional limits placed by modern practice. Unlike any corporate, government or household, a central bank has no reason to be bound by its balance sheet or income statement. It can simply create money out of thin air (a liability) and buy an asset or give the liability (money) out for free. It can run perpetual losses (negative equity) because it can fund these by printing more money.
Taking this fundamental principle on board leaves us with the following menu of policy options, in ascending order of unorthodoxy. We accompany each option with a discussion on the implications for the CB balance sheet.
1. Quantitative easing combined with fiscal policy expansion: This is the least “unconventional” option and is already happening, albeit with a lack of explicit co-ordination. Central banks purchase interest-bearing government debt with a temporary increase in the monetary base.
This is accompanied by increased fiscal spending (or tax cuts), enacted by the Treasury in reaction to implicit central bank support for bond markets. The Treasury has more room to increase the deficit and the outstanding term of its maturing government bonds, because financing costs are made lower by central banks, but this support can be withdrawn at any time. In this case, the central bank’s assets and liabilities rise in parallel: the rise in central bank government bond holdings shows up as an increase in assets, while the increase in private-sector cash holdings shows up as a rise in central bank liabilities.
2. Cash transfers to governments: Same as option (2) except the government debt is non-redeemable, and hence the increase in the monetary base is permanent. Money can be credited directly to the Treasury account at the central bank, which would keep government debt/GDP ratios stable. The central bank can purchase 0% coupon perpetuities from the Treasury, which because they have no value, should amount to the same thing.3 The precise impact on the balance sheet here will depend on the nature of the transaction with the government. In the case where cash is swapped for a zero-coupon perpetuity, assets and liabilities would rise correspondingly, but the central bank would make a loss because it would not receive a coupon on government debt while eventually having to pay interest on bank reserve balances if interest rates rise.
3. Haircuts on existing CB-held debt: The central bank can unilaterally restructure and/or forgive its government debt holdings, improving government debt sustainability and allowing the Treasury room for future deficit spending. This can happen in a one-off fashion, or according to some graduated rule. For instance, the central bank could commit to write off 5% of government debt holdings until some target is achieved. The Greek OSI and PSI experience offers a precedent for distinguishing between privately and publicly held government bond holdings thus potentially avoiding CDS triggers. Note that central bank purchases of negative-yielding instruments are a form of notional haircuts as the government pays back to the central bank less than it issued. The resulting balance sheet change here is also straightforward: the central bank’s assets would be reduced by the corresponding size of the haircut, and this would be registered as a loss on the central bank’s liability ledger.
4. Cash transfers to households: The most radical option has central banks create and transfer money to individuals directly (through cheques, bank transfers or state pension contribution credits), cutting out the role of the Treasury entirely. In this case, the central bank’s liabilities would rise, as the public’s cash holdings against the central bank would show up as a rising liability. If no asset is purchased by the central bank, the rise in the liability would have to be offset by a corresponding loss on the balance sheet in the form of negative equity.
Here is a link to the full report.
Anyone who believes central banks have come close to the end of what can be achieved by monetary accommodation should read this report. When a central bank has the ability to create money out of the nothing there is absolutely no limit to what they can do in an effort to achieve their goals. The results might not be to everyone’s’ liking because items 2, 3 and 4 above would stoke additional asset price inflation but that does not mean they cannot be implemented.
In fact, with upwards of $700 billion of the Fed’s holdings of Treasury debt due to mature between 2017 and 2019 they have some big decisions about what to do with it. The Treasury might well have to pay higher coupons just to refinance the maturing bonds and the resulting tax hikes that would necessitate would not be the most advantageous outcome for the Fed since it wishes to promote inflation.
Considering what we know about quantitative easing and its role in asset price inflation rather than growth, the potential for any of the above outcomes to be introduced would be medium-term bullish catalysts for stocks, bonds and property.
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