Economics Weekly: Fed and ECB’s Balance Sheet Headaches
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Economics Research24 Nov 2023
  • US & Europe: Balance sheets of the Fed and ECB remain outsized despite Quantitative Easing
  • Singapore: 3Q23 growth came in at 1.1% y/y and 1.4% q/q sa, better than advance estimate
  • Indonesia: Despite a small miss in the 3Q GDP numbers, BI expects 4Q growth to be strong
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US & Europe: Fed and ECB Balance sheets remain substantial. Despite steady quantitative tightening (QT), the balance sheets of the two largest central banks in the world remain enormous. After nearly a year and a half of QT, the Fed balance sheet stands at nearly USD8t, which amounts to 30% of US GDP. The corresponding figure for the European Central Bank (ECB) is 50% of the Euro Area GDP, despite an accelerated QT programme relative to that of the Fed.

Quantitative easing (QE) has become a key part of the monetary policy toolbox of major central banks this century. It is clear that with their power to print money and purchase assets, central banks are capable of boosting asset prices, resolving liquidity crises, and reducing deflation risks.

However, bloated central bank balance sheets, built through purchasing financial assets and injecting bank reserves, come with their share of complications and costs. Research by Bank for International Settlements (BIS) and Fed officials have shown that they lead to a financial system where banks are over-reliant on central banks for funding. That, in turn, could distort banks’ incentives to manage liquidity and portfolio risks. QE has also been associated with exacerbating inequality, as such monetary operations favour those with significant ownership of financial assets and property, leaving the rest behind.

At the other end of the operational spectrum, shrinking the balance sheet, which in theory is welcome as it signals normalisation of economic conditions, also comes with its share of risks. As rates rise, central banks take on capital losses on their holding of fixed income assets. Additionally, central banks stepping away from bond buying or holding while there are large fiscal funding needs could end up destabilising the government debt market. Case in point is the US, where there has been a marked rise in volatility in Treasury markets, even as recent easing of long-term interest rates has given the markets some relief.

In our view, G2 central bank balance sheets need to continue to shrink for months and years as the level of balance sheet sufficient for the market’s liquidity needs is several trillions lower. For instance, the current monthly rate of the Fed’s balance sheet reduction will take it from the present level of USD7.8t to around USD6.5t by the end of 2024, still more than ample by historical standards, necessitating further consolidation through 2025 and beyond.

However, complications abound. If growth slows next year and rate cuts are warranted, could they continue alongside QT? That would require the Fed to differentiate between the impact of balance sheet operation from interest rate policy. Can QT continue if bond yields turn volatile or soar? These tough choices lie ahead for the Fed and ECB.

Figure 1: Balance sheet as a share of GDP

Source: Bloomberg, DBS

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