Central Bank Balance Sheet Research Articles

Issues in Central Bank Finance and Independence

Conventional economic policy models focus only on selected elements of the central bank balance sheet, in particular monetary liabilities and sometimes foreign reserves. The canonical model of an central bank assumes that it chooses money (or an interest rate), unconstrained by a need to generate seignorage for itself or government. While a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy the idea that an independent central bank could be constrained in achieving its policy objectives by its own balance sheet situation is a relatively novel idea considered in this paper. If one accepts this potential constraint as a valid concern, the financial strength of the central bank as a stand alone entity becomes highly relevant for ascertaining monetary policy credibility. We consider several strands of evidence that clearly indicate fiscal backing for central banks cannot be assumed and hence financial independence is relevant to operational independence. First we examine 135 central bank laws to illustrate the variety of legal approaches adopted with respect to central bank financial independence. Second, we examine the same data set with regard to central bank recapitalization provisions to show that even in cases where the treasury is nominally responsible for maintaining the central bank financially strong, it may do so in purely a cosmetic fashion. Third, we show that, in actual practice, treasuries have frequently not provided central banks with genuine financial support on a timely basis leaving them excessively reliant on seignorage to finance their operations and/or forcing them to abandon policy objectives.

Issues in Central Bank Finance and Independence

Conventional economic policy models focus only on selected elements of the central bank balance sheet, in particular monetary liabilities and sometimes foreign reserves. The canonical model of an central bank assumes that it chooses money (or an interest rate), unconstrained by a need to generate seignorage for itself or government. While a long line of literature has emphasized the dangers of fiscal dominance influencing the conduct of monetary policy the idea that an independent central bank could be constrained in achieving its policy objectives by its own balance sheet situation is a relatively novel idea considered in this paper. If one accepts this potential constraint as a valid concern, the financial strength of the central bank as a stand alone entity becomes highly relevant for ascertaining monetary policy credibility. We consider several strands of evidence that clearly indicate fiscal backing for central banks cannot be assumed and hence financial independence is relevant to operational independence. First we examine 135 central bank laws to illustrate the variety of legal approaches adopted with respect to central bank financial independence. Second, we examine the same data set with regard to central bank recapitalization provisions to show that even in cases where the treasury is nominally responsible for maintaining the central bank financially strong, it may do so in purely a cosmetic fashion. Third, we show that, in actual practice, treasuries have frequently not provided central banks with genuine financial support on a timely basis leaving them excessively reliant on seignorage to finance their operations and/or forcing them to abandon policy objectives.

Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

A Theory of Deflation

This paper explores the link between fiscal-monetary policy interaction and deflation. The key feature of this paper is that the central bank's balance sheet is separated from the government's budget constraint. As a result, government bonds are held entirely by households, and money is supplied via helicopter drops. This paper finds that helicopter money can be used as a subsidy to purchasing government bonds. Then, the central bank's commitment to a low nominal interest rate implies that it must inject money to keep the price of government bonds from falling when debt increases. The injection of helicopter money also increases the demand for real money, raising the value of money.

Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

Central banks target CPI inflation; independent central banks are concerned about their balance sheet and the level of their capital. The first fact makes it difficult for a central bank to implement the optimal escape from a liquidity trap, because it undermines a commitment to overshoot the inflation target. We show that the second fact provides a solution. Capital concerns provide a mechanism for an independent central bank to commit to inflate ex post. The optimal policy can take the form of a currency depreciation combined with a crawling peg, a policy advocated by Svensson as the “Foolproof Way” to escape from a liquidity trap. (JEL E31, E52, E58, E62)

Comments and Discussion

Comments and Discussion Benjamin M. Friedman and Lars E. O. Svensson Benjamin M. Friedman: This paper by Ben Bernanke, Vincent Reinhart, and Brian Sack is a welcome contribution to the new line of literature that examines, in a far more eclectic way than used to be done, how monetary policy works and what effects it has on the financial markets and the non-financial economy. The paper is valuable both because the question it asks is important—whether what the authors call nonstandard policy measures can be effective when ordinary monetary policy actions are constrained by the zero lower bound on short-term nominal interest rates—and because the analysis it brings to bear on this question is largely empirical. The paper also reaches what I regard as a sensible conclusion: that the potential efficacy of these nonstandard measures notwithstanding, it is wise for monetary policy both to aim at an inflation rate distinctly above zero, so as to allow for a buffer against disinflationary shocks, and to ease policy preemptively when necessary to avoid significant risk of hitting the zero lower bound on interest rates. Finally, the paper is important also because of who wrote it, but more on that below. The authors consider three conceptually distinct classes of nonstandard monetary policy measures: central bank communications, changes in the size of the central bank's balance sheet, and changes in the composition of the central bank's balance sheet. (The last of these is what would normally be called debt management policy if it were executed by a country's fiscal authority rather than by its central bank.) It is important to point out, however—and this is the focus of my one major concern about the paper—that even when the authors are addressing the effects of changes in the size or composition of the central bank's balance sheet, what they are actually analyzing in their empirical work is still communications. Most [End Page 79] of their empirical exercises focus not on policy actions but on official statements regarding intended future actions. Even when they examine such episodes as the U.S. Treasury's buyback of Treasury securities, during the happy but all-too-brief period in the late 1990s when the U.S. government ran surprisingly large budget surpluses instead of shamefully large deficits, their attention is more on what the Treasury said than on what it did. In principle, of course, credible statements about future actions should matter for the pricing of medium- and long-term assets in speculative markets. The ground for concern is rather in how this approach to addressing questions of monetary policy reinforces the increasingly exclusive focus in recent literature on what many economists engaged in this line of research (for example, Gauti Eggertsson and Michael Woodford in a Brookings Paper last year)1 call "expectations management." Surely everyone today believes that expectations matter, and therefore that whatever influences the public's expectations, including communication from the central bank, matters as well. I am also sympathetic to the authors' presumption that, when an economy has reached the zero lower bound on short-term interest rates, central bank communications may be even more important than normally. But the net impression, delivered both by the authors' discussion and by the battery of empirical tests they perform, nonetheless resonates too strongly, at least for my taste, with the idea, which they attribute to Eggertsson and Woodford, that "shaping the interest rate expectations of the public is essentially the only tool that central bankers have—not only when the ZLB binds, but under normal conditions as well." (I will not repeat here my criticism of this view, but interested readers can refer to my remarks as a discussant of the Eggertsson-Woodford paper.) This concern aside, I regard the authors' empirical analysis of the effect of Federal Reserve and Treasury statements on market interest rates as carefully crafted, and I find their conclusions easily credible. I especially admire their willingness to go beyond the standard event studies and use a multifactor term structure model to try to identify the role of "surprise" elements of Federal Reserve statements, as distinct from the policy actions that these...

Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment

THE CONVENTIONAL INSTRUMENT of monetary policy in most major industrial economies is the very short term nominal interest rate, such as the overnight federal funds rate in the case of the United States. The use of this instrument, however, implies a potential problem: Because currency (which pays a nominal interest rate of zero) can be used as a store of value, the short-term nominal interest rate cannot be pushed below zero. Should the nominal rate hit zero, the real short-term interest rate--at that point equal to the negative of prevailing inflation expectations--may be higher than the rate needed to ensure stable prices and the full utilization of resources. Indeed, an unstable dynamic may result if the excessively high real rate leads to downward pressure on costs and prices that, in turn, raises the real short-term interest rate, which depresses activity and prices further, and so on. Japan has suffered from the problems created by the zero lower bound (ZLB) on the nominal interest rate in recent years, and short-term rates in countries such as the United States and Switzerland have also come uncomfortably close to zero. As a consequence, the problems of conducting monetary policy when interest rates approach zero have elicited considerable attention from the economics profession. Some contributions have framed the problem in a formal general equilibrium setting; another strand of the literature identifies and discusses the policy options available to central banks when the zero bound is binding. (1) Although there have been quite a few theoretical analyses of alternative monetary policy strategies at the ZLB, systematic empirical evidence on the potential efficacy of alternative policies is scant. Knowing whether the proposed alternative strategies would work in practice is important to central bankers, not only because such knowledge would help guide policymaking in extremis, but also because the central bank's choice of its long-run inflation objective depends importantly on the perceived risks created by the ZLB. The greater the confidence of central bankers that tools exist to help the economy escape the ZLB, the less need there is to maintain an inflation buffer, and hence the lower the inflation objective can be. (2) This paper uses the methods of modern empirical finance to assess the potential effectiveness of so-called nonstandard monetary policies at the zero bound. We are interested particularly in whether such policies would work in modern industrial economies (as opposed to, for example, the same economies during the Depression era), and so our focus is on the recent experience of the United States and Japan. The paper begins by noting that, although the recent improvement in the global economy and the receding of near-term deflation risks may have reduced the salience of the ZLB today, this constraint is likely to continue to trouble central bankers for the foreseeable future. Central banks in the industrial world have exhibited a strong commitment to keeping inflation low, but inflation can be difficult to predict. Although low inflation has many benefits, it also raises the risk that adverse shocks will drive interest rates to the ZLB. Whether hitting the ZLB presents a minor annoyance or a major risk for monetary policy depends on the effectiveness of the policy alternatives available when prices are declining. Following a recent paper by two of the present authors, (3) we group these policy alternatives into three classes: using communications policies to shape public expectations about the future course of interest rates; increasing the size of the central bank's balance sheet; and changing the composition of the central bank's balance sheet. We discuss how these policies might work, and we cite existing evidence on their utility from historical episodes and recent empirical research. The paper's main contribution is to provide new empirical evidence on the possible effectiveness of these alternative policies. …

Editors' Summary

Editors' Summary The brookings panel on Economic Activity held its seventy-eighth conference in Washington, D.C., on September 9 and 10, 2004. This issue of Brookings Papers on Economic Activity includes the papers and discussions presented at the conference. The first paper evaluates unconventional measures available to monetary policymakers for stimulating the economy when interest rates are already near zero, a situation that may arise with price stability or negative inflation. The second paper presents empirical evidence on the effects of taxes, federal spending, and deficits on national saving, interest rates, and growth. The third paper explores the impacts on U.S. employment in recent years from conventional foreign trade in goods and from the rise in offshoring of service jobs. The fourth paper examines the effect of tax changes, such as those passed since 2000, on business capital formation. Central Banks Usually implement monetary policy by setting the short-term nominal interest rate that the bank controls, such as the federal funds rate in the United States. However, the success of many industrial countries over the years in reducing inflation and, consequently, average nominal interest rates has increased the likelihood that, during a recession, the policy rate will approach its lower bound of zero. When rates are at or near zero, a central bank can no longer stimulate aggregate demand by further rate reductions and must rely instead on "nonstandard" policy alternatives. An extensive literature examines these alternatives, but for the most part from a theoretical or historical perspective. Few studies have presented empirical evidence on their potential effectiveness in modern economies. Such evidence not only would help central banks plan for the contingency of the policy rate approaching zero, but also would bear directly on the choice of the appropriate inflation objective in normal times: the greater the confidence of central bankers that tools exist to help the economy escape [End Page ix] the liquidity trap that occurs at the zero bound, the less need there is to maintain an inflation "buffer." Hence evidence of effective alternative policies would bolster the argument for a lower inflation objective. In the first article of this issue, Ben Bernanke, Vincent Reinhart, and Brian Sack apply the tools of modern empirical finance to the recent experiences of the United States and Japan to look for such evidence.1 Following earlier work by Bernanke and Reinhart, the authors group nonstandard policy alternatives into three classes: official communications designed to shape public expectations about the future course of interest rates; quantitative easing, which increases both assets (holdings of government securities) and liabilities (unborrowed reserves) on the central bank's balance sheet; and changes in the composition of that balance sheet through, for example, targeted purchases of long-term bonds aimed at reducing long-term interest rates. The authors' investigation employs two approaches. First, they perform event-study analysis, measuring and analyzing the behavior of selected asset prices and yields over short periods surrounding central bank statements or other financial or economic news. Second, they estimate "no-arbitrage" models of the term structure of interest rates for both the United States and Japan. For any given set of macroeconomic conditions and stance of monetary policy, these models allow the authors to predict interest rates at all maturities. Using the predicted term structure as a benchmark, they are then able to assess whether factors not included in the model—such as the Bank of Japan's quantitative easing policy that began in 2001—have economically significant effects on interest rates. Bernanke, Reinhart, and Sack begin with a discussion of nonstandard policies that might be effective in stimulating the economy when short-term rates are at the zero bound; the discussion draws on the historical experience with such policies in the United States and Japan as well as on existing theories of potential policy channels and previous empirical analysis. The first type of policy they consider is the use of central bank communications to influence the market's expectations about future policy and hence future short-term rates. According to some theories, shaping expectations about future short-term rates is essentially the only tool central bankers have. But the authors take a broader view, arguing that...

Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

An independent central bank can manage its balance sheet and its capital so as to commit itself to a depreciation of its currency and an exchange rate peg. This way, the central bank can implement the optimal escape from a liquidity trap, which involves a commitment to higher future inflation. This commitment mechanism works even though, realistically, the central bank cannot commit itself to a particular future money supply. It supports the feasibility of Svensson's Foolproof Way to escape from a liquidity trap.

Credible Commitment to Optimal Escape from a Liquidity Trap: The Role of the Balance Sheet of an Independent Central Bank

An independent central bank can manage its balance sheet and its capital so as to commit itself to a depreciation of its currency and an exchange-rate peg. This way, the central bank can implement the optimal escape from a liquidity trap, which involves a commitment to higher future inflation. This commitment mechanism works even though, realistically, the central bank cannot commit itself to a particular future money supply. It supports the feasibility of Svensson’s Foolproof Way to escape from a liquidity trap.

Cash versus E-Cash: A New Estimation for the Euro Area

Several methods for assessing the substitution of electronic money for fiat money have been proposed in the last few years. After a critical review of the various models, we propose a new substitution model which we apply to the euro area. By way of several numeric simulations, we show that the maximal reduction of fiat money supply can be estimated at 35%. The projected monetary effects in terms of seigniorage and changes to the structure of the European Central Bank's balance sheet could be more significant than envisaged initially in previous studies. This important result does not, however, justify the conclusion of certain authors that the monetary impact is likely to destabilise current monetary systems.

Monetary Policy in Japan: Lessons to Draw When Comparing it with the US

Japan's experience shows that very negative circumstances are required for a country to suffer from protracted deflation. The comparison of Japan's developments in the last few years with those of the US points to large differences, which suggest that the risk of deflation in the US is low. However, the analysis of the deflation spiral in Japan could be useful to draw lessons for other countries. The first lesson to draw is that deflation is very costly and that it is difficult to anticipate. Authorities should, thus, react aggressively to avoid zero interest rates, since reaching the zero bound drastically reduces the effectiveness of monetary policy. Before reaching the zero-bound, it seems useful to adopt an inflation targeting regime, perhaps accompanied by an explicit compromise of maintaining interest rates at very low levels for a predetermined period. When zero bound is reached, the authorities still have policy instruments to fight against deflation, among them heterodox monetary measures, expansionary fiscal policy and/or substantial exchange rate depreciation. The case of Japan points to the large potential costs of these options, in terms of the central bank's balance sheet, the sustainability of the fiscal accounts and, potentially, the stability of the international monetary system. However, Japan's protracted stagnation and deflation is bound to be more costly.

Monetary Operations and Central Bank Balance Sheets in a World of Limited Government Securities

The limited supply of government securities in some industrial countries has important ramifications for the operating techniques used by central banks to implement monetary policy, provide credit to the financial sector, and also for the assets they hold on their balance sheets. The paper reviews the salient facts regarding industrial central bank balance sheets and operating techniques, and outlines different options for dealing with a limited supply of government securities. The main conclusion is that central banks may wish to consider extending credit using a broad range of assets as collateral, and engage in outright transactions of securities guaranteed by financial institutions.

Fiscal Aspects of Central Bank Independence

Most macroeconomic models treat the central bank and the trea- sury as a unifled entity. The balance sheet of the central bank is therefore implicitly treated as an accounting flction. While this is often realistic, the central bank balance sheet has implications for central bank independence. There are wide difierences in the nature of central bank balance sheets today, with the US and ESCB balance sheets nearly at the extremes. The reasons for and implications of these difierences are studied here. I. Introduction There are two ideal models of a central bank, of which actual central banks are usually a mixture. In type F, which is close to describing the US Federal Reserve system, the central bank's balance sheet is always perfectly hedged, with short term interest-bearing nominal bond assets and high-powered money liabilities that leave almost no risk of balance sheet problems. There is a single government budget constraint, re∞ecting the certainty that mature government bonds can always be redeemed for high powered money and the fact that there is no doubt that potential central bank balance sheet problems are nothing more than a type of flscal liability for the treasury. In type E, which seems to be the model underlying the constitution of the ECB and which (in an extreme version) is close to matching currency-board arrangements like that in Hong Kong, the central bank holds assets whose return distributions do not match those of its liabilities, but are intended to act as reserves, guaranteeing a lower bound on the value of its high-powered money liabilities in terms of some other store of value. In this model, the central bank budget constraint is distinct from that of the treasury (or in the case of the ECB, treasuries). Mature nominal government debt might not, in some circumstances, be convertible at par into high-powered money, and conversely it is not obvious

Implementation of Monetary Policy and the Central Bank's Balance Sheet

This paper discusses how the choice of central banks' operating targets influences the use of their monetary policy instruments and how the latter affect the central bank's balance sheet. This is of particular interest, since the monetary conditionality in IMF-supported programs has traditionally been linked to central bank balance sheet items. Quantity targeting tends to be practiced today mostly in countries in which money markets are not yet well-developed or a monetary aggregate is used as the intermediate target. Most other central banks prefer to target a short-term interest rate, which results in day-to-day changes in balance sheet items becoming endogenous.

Implementation of Monetary Policy and the Central Bank's Balance Sheet

This paper discusses how the choice of central banks' operating targets influences the use of their monetary policy instruments and how the latter affect the central bank's balance sheet. This is of particular interest, since the monetary conditionality in IMF-supported programs has traditionally been linked to central bank balance sheet items. Quantity targeting tends to be practiced today mostly in countries in which money markets are not yet well-developed or a monetary aggregate is used as the intermediate target. Most other central banks prefer to target a short-term interest rate, which results in day-to-day changes in balance sheet items becoming endogenous.

CAN A CENTRAL BANK GO BUST?

Central banks publish profit figures that are invariably well below the amounts implied by calculations of their seigniorage revenue. Most of the difference is due to the impairment of central bank balance sheets by the acquisition of substandard assets and of liabilities not matched by assets of equal value. In the limit, a central bank can go bust when it has acquired liabilities of greater market value than the present value of its seigniorage revenue calculated for any steady-state inflation rate. An insolvent central bank can continue to service its liabilities only through accelerating inflation. Copyright 1992 by Blackwell Publishers Ltd and The Victoria University of Manchester

The Case for Raising the Price of Gold

THE ESTABLISHMENT OF a two-tier gold price in March 1968 has been widely interpreted as pointing to the eventual disappearance of gold from the world monetary system. More precisely, economists have emphasised that the two-tier price is an interim solution. It must lead eventually either to a complete demonetisation of gold, involving the gradual disposal of monetary gold stocks to private buyers and their replacement in central-bank balance sheets by some form of credit money, or to a substantial rise in the official price of gold, probably allowing the two markets to be reunited. Many economists consider that demonetisation is the only sensible obiective. Some of them, however, recognize that central-bank preference for gold may exclude demonetisation for the time being and thereby render an increase in the price unavoidable; but they would view this as a regrettable necessity and a stop-gap, rather than as a genuine solution to the problem. The purpose of this paper is to argue that the economic case for a higher gold price is far more powerful than its opponents have recognized. The paper falls into four sections. Section I outlines the way in which a higher gold price would contribute to international monetary equilibrium. Section II discusses objections to the monetary use of gold, notably the opportunity cost of gold reserves for the world economy. Section III takes a cursory look at alternatives to gold and Section IV is a brief summing up. The basic insight into the structure and functioning of the gold/dollar system which underlies the argument of Section I is due to Milton Gilbert [1X; see also the much earlier paper by Kenen, 6]. The economic profession has not done justice to Gilbert's contribution, partly no doubt because of the