The $19 trillion bond question confronting central banks

We all care about the interest rates that central banks set, but what about the $19 trillion of bonds and other assets(1) by the biggest among them? Those constitute a more esoteric, but equally consequential, element of monetary policy that’s lately transcended the wonky to become politically fractious. Supporters credit bond purchase programs with stimulating the economy in times of need by lowering longer-term borrowing costs and tamping down market disruptions. Opponents blame them for widening inequality, among other things.

What becomes of these bonds is an issue of critical importance to governments, businesses and households because they influence the cost of money. And because detractors say they are a big reason why trust in central banks has tumbled.

With the elevation of Kevin Warsh to chair of the Federal Reserve, those skeptical of the accumulation of bonds on central bank balance sheets have won the day. Warsh and Bank of England Governor Andrew Bailey(2) are leading the charge to actively shrink these holdings, with the former starting a task force on the effort and the latter selling securities outright. They hope that unwinding the programs used during crises including the 2008 subprime mortgage meltdown and COVID-19 will bolster central bank legitimacy and, ultimately, safeguard their independence from political pressure.

There is no doubt that the balance sheet experiment of the past two decades, known as quantitative easing, came with unintended consequences. The world’s four most important developed-market central banks amassed almost $27 trillion in assets at the peak, the equivalent of more than half the output of the economies they were charged with managing. The Bank of Japan so dominated its nation’s bond market at one point that trading in government securities thinned to nothing on some days. The Fed’s purchases of mortgage-backed securities helped to deliver record low home-loan rates, fueling a rally in house prices and an affordability crisis. The programs also seemed to blur the lines between independent central banks and Treasury departments, at times angering taxpayers and at others influencing fiscal policy.

The risk now is for the pendulum to swing too far back and for some central banks to abandon what is a genuinely useful form of economic medicine. For all their inadequacies, large-scale bond purchases helped countries dig their way out of some crises and avoid others. They also supplied ample reserves to an ever-growing and accelerating financial system. Corporate tax, currency and securities settlements occur today on an unprecedented scale, and ready liquidity has prevented sudden intraday outflows from leaving banks cash-strapped and the system in danger of seizing up.

The path ahead demands nuance, not dogma: Reduce the holdings a bit, minimizing distortions by matching the maturities of the bonds retained to the market; but also, stand ready to reverse course if another emergency materializes. The balance sheet tool is far too important for risk mitigation and policy triage for central banks to jettison it from their arsenal completely.

How far should the big central banks go? The question can only be answered by first acknowledging that regulation and innovation have fundamentally reshaped the financial system since the 2008 global financial crisis. Payment architectures are evolving toward an around-the-clock schedule to meet demand from our always-on and globally connected markets; there’s also a burgeoning stablecoin industry. Central bank balance sheets aren’t just relics of an emergency response; they are a shock-absorber that keeps the plumbing of global markets unclogged.

Today’s balance-sheet policies were born, around the turn of the millennium, of the BOJ’s battle to end persistent deflation once short-term policy rates had hit their floor. The BOJ formally began targeting bank reserves — created through the purchase of government securities from lenders and via other operations — in 2001, following criticism that it had done too little to counter Japan’s "Lost Decade." Among the critics: Princeton University economist Ben Bernanke, who would go on to become Fed chair.

With Bernanke at the helm in 2008, the Fed took inspiration from the BOJ once the collapse of Lehman Brothers sent the U.S. economy into a tailspin. The Fed’s bond purchases were followed by similar programs from the BOE and European Central Bank. Their actions were the only viable way to stimulate economies in the absence of fiscal assistance after the initial crisis response. The rise of the Tea Party wing of America’s Republican Party encouraged an ill-conceived burst of anti-deficit politics even though unemployment was still high, and the austerity trend spread through Europe.

The bond purchases successfully lowered longer-term rates and injected cash into the financial system, helping to boost demand for riskier financial assets such as equities and corporate bonds, thereby making households feel a bit richer and able to spend again. Little wonder that central banks went back to that well again and again — in response to the threats of Japanese and European deflation, the US’s jobless recovery of the 2010s and the COVID-19 pandemic.

Then came the global pandemic and the worst economic crisis since the Great Depression. Inflation remained mostly timid, until the mother of all globally coordinated asset purchases was unleashed during the pandemic. The BOJ’s balance sheet ballooned to 133% of gross domestic product, the ECB’s to 68%, the BOE’s to 42% and the Fed’s to 37%, all records. All this monetary stimulus arrived in conjunction with historic fiscal stimulus and a sequence of supply-chain snarls, pushing consumer prices to the highest in recent memory globally. The trade off of saving the global economy from a worse calamity was that the stimulus also was seen to widen inequality by increasing prices of financial assets generally held by the wealthy such as stocks, bonds and real estate.

That brings us to the knotty question of what happens now. 

If quantitative easing was essentially conceived as a tool for helping stimulate economies with policy rates near zero, it’s unlikely to serve much good in an economy with moderately high rates and above-target inflation. It makes sense to wind bond holdings down, both to mitigate any adverse side effects and to ensure that there’s ample firepower in the next emergency. And indeed, the ECB has been allowing bonds to "roll off" its balance sheet once they mature, rather than reinvesting them, and the Fed did the same for over three years until late 2025. The BOJ is still purchasing bonds, but less than the quantity maturing. And the BOE has been actively selling gilts, which makes it seem like an outlier, though it’s likely been forced into a more aggressive stance because it holds a greater proportion of longer-maturity assets than its peers; it can’t depend on maturing bonds rolling off its balance sheet alone.

The economic environment isn’t the only consideration. Commercial banks have grown accustomed to a world of ample liquidity even as financial innovations have raised the risk of funding squeezes. Some of this was by design as post-2008 banking rules and supervisory practices encouraged the formation of larger capital cushions, with central banks providing the reserves to build them up. The changes caused the old practice of interbank lending — where lenders transacted with each other to plug short-term borrowing needs — to atrophy. The authorities have begun to tweak the rules, though the culture of hoarding reserves could take time to dismantle.

Trying to shrink the Fed’s holdings without first reducing bank dependence on reserve accumulation and rebuilding the interbank market is a fool’s errand. The Fed tried doing so in 2019, sending money markets — otherwise known as the plumbing of the financial system — into disarray.

Another route, where the BOE is ahead of the pack, tackles the issue by shifting to a different operating model. Instead of keeping the system awash in a semi-permanent supply of reserves — and trying to figure out the right level for that supply — the BOE effectively allows banks to determine demand themselves. The institution established programs where banks can borrow on demand against collateral. Think of the old model as a massive "reservoir" in which the authorities try to guess and then meet the demand for water; now, each commercial bank essentially gets its own faucet. Although the BOE has seen episodic pressure in the repo market for short-term loans, it hasn’t experienced anything like the 2019 episode in the U.S., despite its active sales of gilts.

A demand-driven framework is also theoretically possible at other central banks, but the nature and size of each market is distinct. History supplies little evidence as to how this will end, especially at institutions as unique and important as the BOJ and the Fed, a steward of the world’s reserve currency.

It’s reasonable for central banks to pare their reliance on a program that entered the global central banking tool kit at a time when inflation and interest rates were much lower. But there are demonstrated execution risks, while the benefits are still hazy. Policymakers must proceed with extreme caution and an open mind about the end-goal. So, start to reduce the balance sheet dose, but don’t discontinue the medicine.

This column reflects the personal views of the author and does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Jonathan Levin is a columnist focused on U.S. markets and economics. Previously, he worked as a Bloomberg journalist in the U.S., Brazil and Mexico. He is a CFA charterholder.