CENTRAL BANKS” BALANCE SHEET POLICIES: Effective in a crisis but with limitations

Balance sheet policies, such as quantitative easing, can be an effective alternative tool for stimulating the economy when the interest rate set by the central bank is zero and cannot be lowered any further. That is one finding of new research by Andreas Schabert and Markus Hörmann, published in the December 2015 issue of the Economic Journal.

But their study also suggests that the impact of these policies is limited. While the researchers'' simulations show that balance sheet policies can be particularly effective in mitigating economic and financial crises, beyond a certain threshold, the policies become ineffective.

Schabert and Hörmann draw three implications for policy from their analysis:

• First, the results suggest that when considering balance sheet policies, monetary policy-makers should assess whether the limits of these policies have already been reached. If so, further steps would be ineffective and should be discarded.

• Second, as the potential benefits of balance sheet policies are limited, risks should be carefully analysed and weighed against the expected benefits.

• Third, the type of instrument applied should be adapted to the specific situation of the economy. ''Quantitative easing'' (which increases the central bank''s balance sheet) can address shortages of liquidity that can occur in financial crises; while ''collateral policy'' (which changes the composition of the central bank''s balance sheet without affecting its size) could rather be used to support particular segments of financial markets hit by adverse shocks.

After exploiting all available scope to lower policy rates, major central banks around the world have implemented balance sheet policies in recent years. These policies have been implemented without clear theoretical underpinnings. Indeed, standard theory predicts that these policies do not have any impact on the economy.

The researchers contradict this view and show that balance sheet policies can be effective by reducing yields and stimulating aggregate demand, even when the central bank''s policy rate is already at its zero lower bound. The reason is that balance sheet policies can reduce interest rates on non-money market instruments, such as corporate bonds.

These rates can still be positive, even when the policy rate is zero. This is due to the fact that central banks limit the amount of assets eligible for central bank liquidity-providing operations, so that non-eligible assets must offer a higher return to compensate for their lack of liquidity. In other words, eligible assets command a liquidity premium – that is, they trade at a higher price than non-eligible assets.

The two types of balance sheet policies analysed by the authors affect the economy differently. Quantitative easing increases the central bank''s balance sheet – for example, through large-scale asset purchases – thereby raising the supply of liquidity in the economy. This reduces the price of liquidity – the liquidity premium – and thus lowers interest rates on all non-eligible assets. But this policy has a clear limit: at the point where liquidity is in ample supply and liquidity premiums fall to zero, quantitative easing becomes ineffective.

The model simulations in the new study show that the maximum quantitative impact on GDP is very limited in normal times: it is equivalent to the impact of a reduction in the policy rate by around 7 basis points. But in financial crises, when demand for liquidity rises, the central bank can mitigate the impact of negative shocks on GDP by around 50%. Thus, quantitative easing is a potentially powerful tool.

In contrast to quantitative easing, a pure collateral policy changes the composition of the central bank''s balance sheet without affecting its size. More concretely, the central bank can allow certain assets to be eligible in open market operations while others cease to be eligible.

Unlike quantitative easing, collateral policy leaves the supply of liquidity unchanged. It can nevertheless have a positive impact on the economy: for example, by making corporate bonds eligible – while reducing eligibility for other assets such as government bonds – the central bank can induce liquidity premiums that tend to reduce corporate bond yields. This stimulates firms'' demand for investment goods.

This policy can be particularly effective when corporate bond yield spreads peak due to financial market disruptions. Again, this policy can be effective even when the central bank''s policy rate is zero – the only condition is that liquidity is not in ample supply.

''A Monetary Analysis of Balance Sheet Policies'' by Andreas Schabert and Markus Hörmann is published in the December 2015 issue of the Economic Journal. Andreas Schabert is at the University of Cologne, Germany. Markus Hörmann is at the German Federal Ministry of Finance. The views expressed are those of the authors and do not necessarily reflect those of the German Federal Ministry of Finance.