It could take a generation for central bank balance sheets to normalize
It could take a generation for central bank balance sheets to normalize
Unless you’ve been living under a rock for the past ten years, you will know that one of the biggest unknowns hanging over financial markets today is central banks’ balance sheets. In an attempt to stimulate economic growth following the crisis, central banks around the world have gobbled up bonds in a bid to push down interest rates, lowering finance costs for companies around the world.
Now banks find themselves in a catch-22 situation. The markets are addicted to QE, and there’s no telling what will happen to interest rates without monetary stimulus. However, central banks can’t begin to sell down their bond holdings because they are own such a large proportion of the market. Any significant sales would inevitably drive up interest rates.
These challenges are forcing policymakers to rethink the roles of central banks. Some analysts have speculated that the economy is now reliant on unconventional monetary policy. Central bank rhetoric appears to support this view. Federal Reserve policymakers have acknowledged that their $4 trillion balance sheet will not shrink any time soon, Bank of England officials talk of crisis-fighting tools as now semi-permanent fixtures and the Bank of Japan has developed a new monetary policy framework.
Interestingly, this isn’t the first time central banks have found themselves in such a position. Analysts at Source, the multi-asset research platform, point out that after the financial crisis the balance sheet/GDP ratios for the BoE and Fed peaked at around 25%. This has only happened once before in the history of the Federal Reserve but the Bank of England has grappled with this anomaly several times before.
It could take a generation for central bank balance sheets to normalize
The Fed’s balance sheet ratio previously reached 23% in 1940, while that of the BoE approached 20% in the 1730s (South Sea Bubble), 1816/17 (the Great Re-coinage), 1830s/40s (mounting cost of wars) and in the immediate aftermath of WW2. In every scenario above, the central banks managed to unwind their balance sheets (before the financial crisis balance sheet/GDP ratios started at around 5%). The bad news is that this great unwinding took decades, up to 60 years in some cases, which is almost certainly more than a generation for some of the earlier examples.It may be different this time around. As the chart below shows, central bank balance sheets tend not shrink to any meaningful degree after bank balance sheet expansion stops. Instead, normalisation occurs via GDP growth rather than balance sheet shrinkage. If that continues to be the case, normalisation will depend upon the rate of nominal GDP growth. Assuming history repeat itself in central banks don’t unwind balance sheet holdings, according to Source’s calculations it will take 28 years for a central bank’s balance sheet/GDP ratio to fall from 25% to 5% if GDP grows by 6% year. It will take 42 years if GDP growth is 4% and the 82 years if growth is 2% per annum.
Given that annualised nominal GDP growth has been around 3% for the past decade for both the UK and the US, and most analysts expect economic growth to be below trend for the next few decades (demographic forces, debt and a prolonged crisis recovery) it is not unreasonable to suggest that it could be nearly a century before the Fed and BoE’s balance sheet/GDP ratio has returned to a more normal 5%.
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