The U.S. Federal Reserve is preparing to reduce the number of bonds it owns stemming from the massive quantitative-easing programs that ended in 2014. That step is further out for its counterparts in Europe and Japan, though central banks in both places are seen scaling back their bond buying next year. After the three central banks cumulatively bulked up their balance sheets to more than $14 trillion, the unwind has the potential to influence a slew of markets, from stocks and bonds to currencies and even real estate.
1. What’s a central-bank balance sheet anyway?
As with all balance sheets, there are assets and liabilities. Where a regular bank counts its loans as its main assets, the Fed, European Central Bank and Bank of Japan have government bonds, among other securities. On the liabilities side, instead of deposits from individuals and companies like at commercial banks, central banks have the cash deposits of commercial banks themselves. Also on the liabilities side: banknotes, which are effectively promissory notes from the central bank. The Fed’s and BOJ’s liabilities include their respective governments’ cash deposits (which come, for example, from tax revenue).
2. So how did they get so big?
Through quantitative easing, or QE, programs, central banks bought government bonds and other securities, inflating the asset side of the balance sheet. They created money to pay regular banks for those securities, and those funds then were deposited at the central banks -- inflating the liability side by equal amounts.
3. And how do they shrink?
Say that one of the government bonds the Fed had bought matures. The Treasury "pays" for it through a reduction in its deposits at the Fed. The asset side of the Fed’s balance sheet shrinks by the amount of the Treasury note, and the liability side declines by the same amount. Unless the federal government raises additional revenue or cuts spending, the U.S. Treasury will need to replace the note that just matured by selling another one to the commercial banks that act as intermediaries for investors. When that happens, commercial-bank reserves at the Fed decline and the Treasury’s cash balance rises. In other words, the Fed’s balance sheet has now contracted, as have the funds commercial banks can use to lend to businesses and home buyers.
4. What about just canceling the debt?
This has come up in Japan, which has the world’s biggest government debt burden. Say the government swapped some of the bonds the central bank has for a new note that never expires -- so never needs to be paid off -- and has no interest payments. The government would now be free of the burden. But that hasn’t changed anything on the liability side for the central bank. Remember, it created reserves at commercial banks to pay for the government bonds at the beginning. That money is still there. And, as the economy reflates and interest rates go up, it will have to pay more interest on that money. So there’s no free lunch -- if the government doesn’t pay, the central bank will have to.
5. Did you say banknotes are on the balance sheet?
They are classified as a liability, though they have no maturity or ongoing cost to the central bank once they’re printed. Theoretically, if consumer demand for banknotes climbed, then commercial banks would exchange their reserves at the central bank for banknotes. And if that happened, the public sector -- the government plus central banks -- could escape paying interest on the liabilities previously created. However, banknotes already make up a higher share of money than has historically been the case, so the demand for them would be unlikely to surge. And if inflation picks up as central banks anticipate, the real value of banknotes will decline. Again, no free lunch: Either the government or central bank pays interest, or citizens pay with less valuable banknotes.
6. OK, so what happens to markets?
This is the big debate. It all depends on the condition of the economy, the effectiveness of policy makers’ communication and the deftness of their execution. In May 2013, then-Fed Chairman Ben S. Bernanke surprised investors when he said the central bank could start phasing out its QE later that year -- a warning that sent U.S. Treasuries, emerging-market stocks and currencies tumbling in the so-called taper tantrum. By contrast, Fed officials have given the markets plenty of advance notice about its plans to contract the balance sheet, which economists expect to begin next month, and it’s hard to detect any effects so far. But this is uncharted territory, so it’s tough to predict how markets will react as central banks exit.
7. What’s the worst-case scenario?
Emerging markets have been big beneficiaries of the central banks’ bond-buying sprees in recent years. Deutsche Bank AG analysts calculated that for every $100 increase in the Fed’s balance sheet, some $15 ended up in Asian equity and debt markets. So with potentially trillions of dollars of contraction to come, emerging markets could get roiled again, as they did in 2013, when Indonesia’s rupiah tumbled more than 20 percent and within several weeks premiums on emerging-nation bonds soared by over a percentage point and their equities slid more than 15 percent. In the U.S., a jump in borrowing costs could cause a retrenchment in everything from home sales to car purchases. And perhaps the biggest danger: Without regular and massive central bank bond purchases, there’s less of a shock absorber if something happens that sparks turmoil.
- A QuickTake Q&A on what we know of the Fed’s specific plans and a QuickTake on central banks’ use of forward guidance.
- A Bloomberg News article on how China’s central bank balance sheet differs from those of developed nations.
- A Fed guide on how it conducts monetary policy and the balance-sheet effects.
- An ECB explainer on how money is created in the euro zone.