The Power of Central Bank
Balance Sheets
Keynote Speech by Athanasios Orphanides
When interest rate policy is hampered by the Zero Lower Bound(ZLB), quantitative easing and other balance sheet policies become
essential tools for responding to a crisis or deﬂationary shock.
By unleashing the power of their balance sheets at the onset ofthe pandemic, without the hesitation observed in past encounterswith the ZLB, the Federal Reserve, the European Central Bankand the Bank of Japan provided monetary easing that cushioned
the economic blow, served as a backstop to government securities
and private assets that prevented a ﬁnancial market meltdown andfacilitated the ﬁnancing of an essential ﬁscal expansion. This paper
examines how this policy success materialized, drawing on lessons
learned from previous encounters with the ZLB, and discusses policy
challenges after the pandemic.
Keywords: Zero lower bound; Balance sheet policies; Quantitativeeasing; Eligibility; Fiscal-monetary interactions
JEL Classiﬁcation: E52, E58, E61

Professor of the Practice of Global Economics and Management at the MIT Sloan Schoolof Management (E-mail: athanasios.orphanides@mit.edu)..............................................................................................................
This paper was prepared for the 2021 BOJ-IMES Conference, “Adapting to the New Normal: Perspectives and Policy Challenges after the COVID-19 Pandemic” held online by
the Institute for Monetary and Economic Studies of the Bank of Japan on May 24–25,
2021. The views expressed are those of the author and do not necessarily reﬂect the oﬃcial views of the Bank of Japan.

MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021
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35

I. Introduction
When interest rate policy is hampered by the Zero Lower Bound (ZLB), quantitativeeasing (QE) and other balance sheet policies become essential tools for responding toa crisis or deﬂationary shock. By unleashing the power of their balance sheets at theonset of the pandemic, the Federal Reserve (Fed), the European Central Bank (ECB)
and the Bank of Japan (BOJ) provided monetary easing that cushioned the economic
blow, served as a backstop to government securities and private assets that prevented aﬁnancial market meltdown and facilitated the ﬁnancing of an essential ﬁscal expansion.
This was a case of policy success. Central banks in advanced economies activatedthe power of their balance sheets without the hesitation observed in previous encounters with the ZLB. Lessons learned from the experience of these central banks in theaftermath of the Global Financial Crisis (GFC), and even earlier, Japan’s encounter
with zero interest rates at the turn of the century, proved valuable for providing usefulpolicy guidance and avoiding pitfalls that contributed to less than ideal outcomes in thepast.
The central bank policy response to the pandemic in 2020 compares favorably tothe earlier episodes in multiple dimensions. First, once the need for monetary accommodation was recognized, in March 2020, QE was prompt and decisive, without thedelay associated with earlier episodes when this critical policy tool was seen as “unconventional” (as QE was referred to for a time in the aftermath of the GFC). Second,
central banks proved more willing to employ the power of their balance sheet to avert
a ﬁnancial meltdown that was developing, as opposed to waiting for sustained market dysfunction and failures of ﬁnancial institutions to justify their interventions, andacting only to contain the systemic nature of the damage. This was achieved by expanding the eligibility of assets for which the central banks deemed important to serve
as a backstop, defusing an incipient panic without costly delay. Third, central banks
were more sensitive to the ﬁscal consequences of their balance sheet policies and more
supportive of ﬁscal expansion. By employing the power of their balance sheets to keep
the cost of government debt ﬁnance low, central banks facilitated extraordinary ﬁscal
expansions that supported rapid reﬂation of the economy and reduced the risk of a
prolonged period of low inﬂation and stagnation.
This paper examines how this policy success materialized, drawing on lessons
learned from previous encounters with the ZLB, and discusses policy challenges after the pandemic.

II. Unleashing the Power of the Balance Sheet at the ZLB
Between March and June 2020, the Fed expanded its balance sheet by $3 trillion dollars. In three months, the Fed “printed” as much high-powered money as it did over theﬁrst 100 years of its history, from 1913 to 2013. The Fed was not alone; the BOJ andthe ECB engineered similarly massive balance sheet expansions (Figure 1). The three
central banks enlarged their balance sheets by creating reserves out of thin air, a powerthat central banks always have in a ﬁat currency regime. The balance sheet expansions
generated monetary ﬁrepower in the range of 15% to 25% of GDP (Figure 2).

36 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

Figure 1 Size of Central Bank Balance Sheet

Note: Monthly data relative to February 2020.

Figure 2 Central Bank Balance Sheet as Ratio to GDP

Note: Monthly data relative to February 2020. Ratio to average GDP over previous four quarters.

37

Figure 3 Three ZLB Episodes: Policy Rate

Note: Monthly data.

Ordinarily, such unprecedented money printing would be cause for alarm. Whenmisused, the power of central bank balance sheets can wreak havoc on the economy.
Textbook responses to a crisis suggest cutting policy rates as the ﬁrst line of defense.
But when interest rate policy is hampered by the ZLB, a balance sheet expansion is theindicated policy response. Issuing reserves and using them to purchase assets and/or
provide liquidity that encourages lending is an eﬀective means of providing monetaryaccommodation without reducing the overnight interest rate. Balance sheet expansions
can be used to compress interest rate spreads, reduce term premia, and boost asset
prices—all operations that can reduce the costs of ﬁnancing for households and businesses, and support aggregate demand.1
Two previous encounters with the ZLB over the past quarter century shaped thepolicy response we observed last year (Figure 3). The ﬁrst episode, which aﬀected only
the BOJ, occurred in the aftermath of the Asian ﬁnancial crisis of the late 1990s. All
three central banks needed to ease policy but the BOJ was constrained and after cutting
rates 50 bps reached zero in February 1999. Additional easing was needed but could
not be achieved through interest rate cuts. What was not fully appreciated at the time
was that equilibrium real rates had been declining around the world and substantial................................
1. Since the late 1990s, an extensive literature has examined the monetary policy challenge at the ZLB (see e.g.
Fuhrer and Madigan [1997] and Krugman [1998]). Reviews of alternative policy options include Goodfriend(2000), Clouse et al. (2003) and Bernanke (2020). Purchases of long-term government debt by the central
bank—the canonical form of QE—was ﬁrst proposed by Keynes in 1930 as a means to counteract the “slump”
that followed the 1929 crash (Orphanides [2004]).

38 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

QE would be necessary to defend against deﬂation, once interest rate policy became
constrained. Although some observers drew attention to the need for QE, overall the
economics profession did not help. The highly stylized models of the macroeconomy
that were popular for academic research at the time assumed that nothing other thanthe central bank’s short-term interest rate matters for the monetary policy transmission,
misleading some policymakers into doubting the power of central bank balance sheetsat the ZLB.
The second episode, is associated with the GFC that followed the decision by US
authorities to let Lehman Brothers collapse in September 2008. Within days of thatdecision and facing the specter of an economic collapse comparable to the Great Depression of the 1930s, the Fed, the ECB and the BOJ lowered interest rates towards
the ZLB and over time developed supportive balance sheet policies (Figures 4 and 5).
Over the subsequent decade, from 2009 to 2019 all three of these central banks expanded their balance sheets to support the economy.
Balance sheet expansions can serve as an imperfect substitute for additional policy easing at the ZLB.2 However, the policy multipliers associated with balance sheet
policies are subject to greater uncertainty than those associated with interest rate policy.
This multiplicative uncertainty typically argues for a more cautious approach to balance
sheet expansions when the ZLB is ﬁrst encountered.3 But gradualism can also provecounterproductive. An overly cautious approach to introducing “unconventional” monetary policy accommodation measures at the ZLB implies that monetary policy will be
too restrictive for some time, risking a prolonged period of low inﬂation and stagnation. Without the necessary accommodation, inﬂation expectations may drift lower andbecome disanchored, making it harder for the central bank to raise inﬂation in linewith its price stability objective. The experience of Japan during the 2000s served as a
cautionary tale of these risks.
In retrospect, the balance sheet expansions after the GFC, during the 2010s were
insuﬃcient to raise inﬂation close to 2%, in line with the price stability goals of the Fed,ECB and BOJ. But the diﬀerences in the experience of the three central banks were
informative. The BOJ adopted an aggressive QE program only since 2013. Though the
ECB initially expanded its balance sheet after the GFC, it subsequently signiﬁcantly
reduced it between 2012 and 2014, a policy error that resulted in an unwelcome decline
in underlying inﬂation. By the time the ECB started expanding its balance sheet once
again in 2015, inﬂation expectations were disanchored and the ECB’s asset purchases
were not as vigorous as they needed to be to reverse this disanchoring of inﬂation
expectations and, consequently, the problem of low inﬂation persisted. Of the three
central banks, the Fed expanded its balance sheet more promptly and consistently after
encountering the ZLB, and managed to bring inﬂation close to its 2% goal and startraising interest rates in the second half of the decade. Measured as a ratio of GDP the
Fed’s overall balance sheet expansion was smaller than that of the ECB and the BOJ,
supporting evidence that prompt and decisive action is a more eﬀective approach for................................
2. See Doniger et al. (2019) and Hofmann et al. (2021) for illustrations of this substitutability.
3. If the eﬀectiveness of interest rate is subject to less uncertainty, another implication of the uncertainty ofbalance sheet policies is that interest rate cuts should be more forceful before the ZLB is reached (Orphanides
and Wieland [2000]).

39

Figure 4 Three ZLB Episodes: Balance Sheet Size

Note: Monthly data.

Figure 5 Three ZLB Episodes: Balance Sheet Ratio

Note: Monthly data. Ratio to average GDP over previous four quarters.

40 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

escaping the ZLB.
The experience with balance sheet policies accumulated after the GFC helped reﬁneestimates of the multipliers associated with balance sheet policies. Although it tooktime, in the aftermath of the GFC, it was eventually recognized that the natural rate ofinterest had declined even more than had been appreciated earlier. Policymakers had
misjudged the stance of policy accommodation for several years.4 More easing would
have been advisable in the decade following the GFC than was recognized in real time.

III. The Response to the Pandemic
By January 2020, inﬂation was lower than policymakers in all three central banks
would have preferred and there was little room for the Fed, and eﬀectively no room
for the ECB and BOJ, to cut rates in response to a deﬂationary shock. The forcefulbalance sheet expansions engineered by the three central banks in the Spring of 2020
reﬂected the recognition that while considerable monetary policy easing was needed torespond to the pandemic, the room for interest rate policy easing was severely limited
or non-existent.
Figure 6 plots the two-year OIS rate in dollars, euro and yen providing a visualsummary of the limited interest rate space available to respond to the pandemic in 2020.
By late February investors expected the Fed to cut rates (and the Fed quickly exhausted
the room available), but that the ECB and BOJ would leave policy rates unchanged attheir slightly negative levels, despite the need for additional accommodation. Figures 7
and 8 track daily developments in the stock and corporate bond markets, summarizing
market participants’ views of the deterioration of economic prospects as the seriousnessof the pandemic was recognized and the success of the global policy response in tacking
the challenge. As can be seen, market jitters already appeared in late February, withstock prices declining and risk spreads notably widening.
In an unscheduled meeting on March 3, the Fed delivered a 50 basis points reduction of the federal funds rate from about 1–5/8% to 1–1/8%. By then, the two-year
OIS rate was well below 1%, suggesting more easing was expected. This ﬁrst easing proved insuﬃcient to arrest the deterioration reﬂected in the prices of stocks andcorporate bonds.
On March 11, the World Health Organization declared the outbreak of the novel
corona virus a pandemic.
At the conclusion of its regularly scheduled meeting on March 12, the ECB announced a series of balance sheet easing measures, with emphasis on liquidity provision, along the lines of programs it had developed in the aftermath of the GFC.
However, the overall market sentiment was that the communication did not deliver
the assurance of decisive action needed to ease market participants’ concerns about thefragility of the euro area.
Following yet another unscheduled meeting, on Sunday, March 15 at 5pm the Fed................................
4. Policy errors of this kind are not uncommon and, to some extent, are unavoidable in light of the limited knowledge available about the structure of the economy and its evolution over time. The economic consequencesof such errors can be mitigated with policy frameworks that stress robustness, cf. Orphanides and Williams(2002).

41

Figure 6 The Limited Interest-rate Policy Space During the Pandemic

Note: Daily data. Two year OIS rate in dollars, euro and yen.

Figure 7 Corporate Debt Spreads

Note: Daily data. Spread of Moody’s BAA and AAA bond yields over 10-year Treasury.

42 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

Figure 8 Equity Indexes

Note: Daily data.

announced its return to the ZLB with a reduction of the federal funds rate by the remaining100 basis points it had available. It further announced an increase in the purchases of Treasury securities and agency mortgage-backed securities (the tools it had
employed for most of its balance sheet expansion after the GFC) and additional liquidity measures supporting the ﬂow of credit to households and businesses (Federal
Reserve Board [2020a, b]).
Simultaneously with these announcements, the Fed also announced a coordinatedcentral bank action to enhance the provision of dollar liquidity via the standing swap
line arrangements (Federal Reserve Board [2020c]). This was a critical demonstrationof global central bank cooperation, along the lines of arrangements that proved immensely successful during the GFC. Joining the Fed, the ECB, and the BOJ were the
Bank of Canada, the Bank of England and the Swiss National Bank.
By the time this announcement was made in Washington on Sunday afternoon, it
was already Monday morning, March 16, in Tokyo. The BOJ moved its scheduled
meeting that was meant to start two days later and grasped the opportunity to announce
a series of additional easing measures together with the coordinated swap line arrangements. These measures included additional purchases of government bonds, corporate
bonds, exchange traded funds and Real Estate Investment Funds. In addition the BOJ
introduced special funds-supplying operations to facilitate corporate ﬁnancing (Bankof Japan [2020]). In eﬀect, the BOJ aggressively employed the power of its balance
sheet to eﬀectively backstop not only government securities but also private assets.
On March 18 the ECB announced the Pandemic Emergency Purchase Programme

43

(PEPP). This represented a new policy innovation that was well received by market
participants. As discussed below, it provided temporary relief to market concerns about
the euro area’s fragility.
Between March 17 and 22, the Fed announced a series of additional easing measures, including funding facilities and the establishment of temporary swap lines withnine other central banks, and funding facilities.
These measures by the three central banks were quite important steps for providing
ﬁnancial support during an episode of intense stress and undoubtedly averted a greater
deterioration of market sentiment than was observed. Yet, despite the onslaught ofglobal policy action during the ﬁrst three weeks of March, equity and credit markets
continued to deteriorate.
Market sentiment turned on March 23. Stock prices rallied and corporate bondspreads tightened notably following a series of new measures announced by the Fedthat underscored the Fed’s resolve to serve as a backstop not only to government securities, as it had already been doing, but also to private credit. Using its authority
under Section 13(3) of the Federal Reserve Act, which can be utilized under “unusualand exigent circumstances”, the Fed established the Primary Market Corporate Credit
Facility for new bond and loan issuance and the Secondary Market Corporate Credit
Facility to provide liquidity for outstanding corporate bonds (Federal Reserve Board[2020d]). The Fed would stand ready to purchase newly issued corporate debt andsupport trading in previously issued debt.
Arguably the most important aspect of these programs was eligibility. The Fedannounced that it was ready to backstop corporate debt issued by businesses with aninvestment-grade credit rating (BBB). Crucially, on April 9 the Fed clariﬁed that debt
that was eligible on March 22 would remain eligible for these programs even if itwere subsequently downgraded. By announcing a commitment to use its balance sheet
to backstop private credit instruments, including “fallen angels”, the Fed eﬀectively
short-circuited the downward spiral in bond and equities prices.5 That ended the global
panic.

IV. Eligibility Boundaries
A central bank can short-circuit adverse market dynamics by using its balance as apotential backstop. Committing to do so promptly can protect against adverse selffulﬁlling equilibria with minimal balance sheet expansion.
But what institutions/markets are considered eligible for balance sheet support?
The BOJ was already engaging in support of both government and private markets,and had signiﬁcant experience with equities and even real estate funds.
Before the pandemic, the Fed had relatively limited similar experience but could
draw on the lessons from its policies after the GFC. By announcing a commitment to
use its balance sheet to backstop private credit instruments, including “fallen angels”,................................
5. With this decision, the Fed also protected the economy from the vulnerability induced by the procyclicalityof credit ratings. The destabilizing role of inappropriate uses of credit ratings by central banks and otherregulatory bodies was acknowledged after the GFC, leading to calls for modiﬁcations in practices (Financial
Stability Board [2010]).

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The Power of Central Bank Balance Sheets

the Fed signiﬁcantly expanded the use of its balance sheet to support markets andeﬀectively short-circuited the downward spiral in bond and equities.
The key was eligibility. In the environment of panic that engulfed global markets
in March 2020, it was not suﬃcient to support selected pockets of the ﬁnancial system
and risk the collapse of other segments. With their actions in March 2020, the BOJ andthe Fed demonstrated an appreciation of the risks.
One segment of global markets, dependent on ECB policies, remained under intense stress beyond the end of March, even after the forceful actions by the BOJ andthe Fed: European government debt markets. The reason for that is that the ECB has
been relying on credit rating agencies to determine the eligibility of government debt
for its monetary policy operations. This is a unique practice, not in line with how anyother central bank is treating the debt of the governments they serve, and a known
source of fragility in the euro area over the past decade.6 In times of turmoil, as experienced in March 2020, concern about downgrades by credit rating agencies can evolve
into a self-fulﬁlling crisis. The result can be a debt rollover crisis not driven by ﬁscal
fundamentals but induced by the ECB’s policy implementation strategy.7
The euro area experienced another intense episode of fragility in March and Aprilof 2020. The fragility is evident in the spreads of government bond yields to OIS rates(Figure 9). These spreads can provide information about episodes when monetary policy transmission is impaired. Ordinarily, they should be very small and fairly stableeven during a crisis. With a smooth monetary policy transmission mechanism, changes
in current and expected interest rate policy over the next two years are reﬂected, eﬀectively one-for-one, to government bond yields with similar maturity. This is conﬁrmed
for the United States and Japan in the ﬁgure, reﬂecting the Fed and BOJ’s success inensuring a smooth monetary policy transmission. With an uneven transmission, these
spreads reﬂect additional premia, as has been the case in the euro area over the past
decade. As can be seen in the ﬁgure, as a consequence of the uncertainty induced by
the ECB’s reliance on credit ratings, spreads diverged in early March 2020, wreaking
havoc in euro area government debt markets.
The policy easing measures announced by the ECB at its regularly scheduled meeting on March 12 did not have the desired eﬀect because the ECB failed to address
the source of this fragility. At the press conference following the meeting, President
Lagarde roiled markets further by stating that the ECB was “not here to close spreads”.
The ECB subsequently took two important decisions (on March 18 and April 22)
aiming to tackle this fragility head on. The ﬁrst of the two was the announcementof the PEPP on March 18. The PEPP entailed signiﬁcant new asset purchases thatwould be explicitly targeted so as to “counter the serious risks to the monetary policy
transmission mechanism” (European Central Bank [2020a]). This was a meaningful................................
6. This peculiar element of the ECB’s strategy for implementing monetary policy can be traced to an unfortunate
decision of the ECB Governing Council in 2005 that delegated the determination of eligibility of euro area
government debt for the ECB’s monetary operations to credit rating agencies. Additional information for thisdecision and its consequences is provided in Orphanides (2020).
7. See Lengwiler and Orphanides (2021) for a stylized model illustrating how the ECB’s collateral framework
gives rise to cliﬀ eﬀects and multiple self-fulﬁlling equilibria in bond yields, inducing occasional sovereign
debt crises that would not otherwise arise.

45

Figure 9 The ECB’s Unique Challenge

Note: Daily data. Spread of 2-year government debt yields over OIS rate.

change from the ECB’s earlier asset purchases programs. The new policy was initiallywell received by markets.
However, as is evident in the ﬁgure, spreads started to widen again soon after. The
widening continued even after March 23 when, as discussed earlier, global stock andbond prices started recovering from their troughs. By mid-April, as global markets
were improving, the ECB faced yet another euro crisis episode.
Once again, the key was eligibility. Doubts about the continued eligibility of euroarea government debt for monetary policy operations induced by the ECB’s relianceon credit rating agencies once again destabilized markets. On April 22, the ECB ﬁnallyaddressed this source of fragility. It announced that it would grandfather the eligibilityof marketable assets used as collateral in its credit operations, and thus the eligibility
for its asset purchase programs (European Central Bank [2020b]). This was the mostimportant decision taken by the ECB during the crisis. In essence, the ECB suspended
the delegation of the determination of eligibility of government debt (as well as othersecurities) to credit rating agencies. The government debt of member states would
continue to retain eligibility as collateral and for inclusion in asset purchase programs,
even if it were downgraded. With this decision, the ECB eﬀectively employed thepower of the central bank balance sheet as a backstop that could protect the euro areafrom self-fulﬁlling adverse equilibria and yet another euro crisis episode.
By expanding the eligibility boundaries for using the power of their balance sheets
the three central banks managed to stabilize markets very quickly and eﬃciently. The

46 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

willingness of central banks to use the power of their balance sheets more broadly thanthey had done in the past was a critical element of the policy success in 2020.
The BOJ had accumulated experience with using its balance sheet as a potential
backstop for both government debt and private assets before the pandemic and employed this experience to provide decisive support in March 2020. Faced with the elevated risks of market collapse, the Fed and ECB decided to similarly expand the use of
the power of their balance sheets as a potential backstop. For the Fed, the turning point
was the March 23 decision to render corporate debt eligible for support with Section
13(3) facilities. For the ECB, the turning point was the April 22 decision to suspend reliance on credit rating agencies for determining eligibility of government debt, thereby
suspending the mechanism that had repeatedly caused unnecessary crises in the euroarea over the previous decade.

V. Monetary-ﬁscal Interactions at the ZLB
Another critical element of the central bank policy success in 2020 was the recognition of the role of central banks and their balance sheet policies for facilitating a ﬁscal
response to the crisis. Similar to the GFC, the pandemic necessitated a forceful ﬁscal response that could have been a challenge for government ﬁnances. The collapseof economic activity in 2020 resulted in larger primary deﬁcits and steeper increases
in debt ratios than observed in the aftermath of the GFC (Figures 10 and 11). Unlike
the GFC, however, the need for extraordinary ﬁscal accommodation was more widely
accepted in 2020 and importantly, central banks recognized their critical role in supporting the ﬁnancing of this ﬁscal response with appropriate central bank balance sheet
policies.8 Concerns about ﬁscal dominance and fears of high inﬂation, similar to arguments that discouraged aggressive QE in the aftermath of the GFC remained. However,these arguments did not dissuade the Fed, the ECB and the BOJ from the forceful balance sheet expansion and associated purchases of government debt that were necessary
under the circumstances in 2020.
To study the role of central bank balance sheet policies for government debt dynamics, it is useful to revisit the familiar equation governing the accumulation of government debt that was already discussed earlier at this conference (Blanchard [2021]).
∆bt = (r L − g)bt−1 + dt .
Here b is the debt-to-GDP ratio, d is the primary-deﬁcit-to-GDP ratio, r L is the realinterest rate on government debt, and g is the real growth rate of GDP. The evolutionof the debt-to-GDP ratio is basically driven by two things: the primary deﬁcit of thegovernment (d) and the diﬀerence between the interest rate and the growth rate of
GDP—what is known as the “snowball eﬀect,” r L – g. For any given ratio existing debt
(bt−1 ) a favorable snowball eﬀect (r L – g < 0) provides additional ﬁscal space for................................
8. The evolution of this understanding in the aftermath of the GFC is usefully documented in the case of the
IMF. See e.g. Independent Evaluation Oﬃce (2014) for an evaluation of the IMF’s premature support for
austerity after the GFC and subsequent change of views.

47

Figure 10 Primary Balance Ratio

Note: Annual data. Vertical lines denote year before each of three ZLB episodes.

Figure 11 Government Debt Ratio

Note: Annual data. Vertical lines denote year before each of three ZLB episodes.

48 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

the government. Central bank policies are critically important for a favorable snowballeﬀect through the eﬀect of their policies on interest rates and growth, especially during
a period of economic weakness.
Over the longer run, the snowball eﬀect is driven by three “stars”: The ﬁrst two
are well known, the equilibrium real interest rate, r*, and the natural real growth rate,g*. Both have declined in advanced economies over the past two decades or so, but the
decline in r* has been far more pronounced. This has been a key factor towards a morefavorable snowball eﬀect in advanced economies. Figure 12 plots the evolution of estimates of these two “stars” for the United States implied in the Federal Open Market
Committee’s Summary of Economic Projections.9 But there is another crucial star variable that matters for debt dynamics and has received less attention: The equilibrium
term premium, τ*.
Governments predominantly reﬁnance their obligations by issuing long-term debt.
The relevant interest rate for the snowball eﬀect in the long run is not the short-term
but the long-term equilibrium real interest rate—that is the sum of the short-term rate
and the term premium. The snowball eﬀect over the long run is: r* + τ* – g*.
The role of the term premium is particularly important at the ZLB because of its
relationship with QE. At the ZLB, expanding the balance sheet with purchases of longdated government debt compresses the term premium on long-term yields.10 The empirical magnitude of this eﬀect is uncertain, reﬂecting the relative scarcity of pertinent
data, but the experience of advanced economy central banks with QE since the GFC
has conﬁrmed that the eﬀect of QE on the term premium is economically signiﬁcantand persistent.11
The term premium on long-term government debt is critical for understanding debt
dynamics. Estimates of the 10-year term premium for the US suggest a notable decline
even before the GFC and the activation of balance sheet policies by the Federal Reserve. This suggests a decline in the equilibrium term premium had taken place prior to
the GFC. Part of this decline can be attributed to monetary policy. The term premiumis positively related to perceived inﬂation uncertainty. The success of central banks
to restore low and relatively stable inﬂation since the 1980s reduced this uncertainty
considerably over the past few decades.
In addition to the likely decline in the equilibrium term premium, τ*, and particularly relevant for the present circumstances, is the additional large decline in the term
premium observed after the GFC which can be attributed to QE (Figure 13).12 The
decline of the term premium observed since the GFC can be expected to persist for................................
9. These are derived from medians of individual policymaker projections for the longer run. Similar policymakerestimates are not available for the BOJ and the ECB. In the case of the BOJ, policymaker projections are only
provided for the short- and medium-term. The ECB has not yet adopted the practice of providing information
about policymaker projections.
10. This reﬂects the imperfect substitutability of assets with diﬀerent duration, cf. Modigliani and Sutch (1967),
Tobin (1969), Andres, Lopez-Salido and Nelson (2004) and Vayanos and Vila (2021).
11. Studies with pertinent estimates of the eﬀect of QE on the term premium and the economy include D’Amico
et al. (2012), Li and Wei (2013), Ihrig et al. (2018), Sudo and Tanaka (2018), Rostagno et al. (2019) and
Kawamoto et al. (2021).
12. Term premia are not directly observed and their estimates are derived from empirical models. The estimates
for the 10-year premium shown in Figure 13, are based on the Fed’s three-factor model (Kim and Orphanides[2012]).

49

Figure 12 FOMC-implied Estimates of “Stars”

Note: SEP median projections for long run. Real GDP growth for g ∗ . Federal funds rate minus inﬂation
goal for r ∗ .

Figure 13 Federal Reserve Balance Sheet and 10-year Treasury Term Premium

Note: Monthly. Term-premium estimates reﬂect the Federal Reserve’s three-factor model.

50 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheetssome time, as central banks continue to operate with relatively large balance sheets toprovide suﬃcient monetary accommodation to circumvent the ZLB. Policy rates will
likely continue to be constrained during economic downturns as long as r* remains
low.
The eﬀect of monetary policy on the term premium and the resulting ﬁscalmonetary interactions are critical for successful policy design in a low interest rateenvironment as we have experienced in the recent past. A low r* limits interest rate
policy easing—the ZLB challenge that has complicated the monetary policy responseto the pandemic last year. At the ZLB, QE can partially substitute for interest rateeasing by boosting prices of longer-term debt and other asset prices (including equities
and real estate). This is the direct monetary easing from QE. By compressing the term
premium, QE also reduces the cost of reﬁnancing government debt and increases theﬁscal space available to the government. QE thus provides indirect easing, throughfacilitating an extraordinary ﬁscal expansion that can be aﬀorded because of the
reduced cost of government ﬁnance.
When the equilibrium real interest rates is low, coordinating ﬁscal and monetary
policy in this fashion is critical for protecting against debt-deﬂation and avoiding policy
mistakes. Explicitly accounting for debt dynamics and monetary-ﬁscal interactions inotherwise standard policy models can avoid pitfalls that appear to have contributed toexcessive ﬁscal austerity and insuﬃcient monetary accommodation in some economies
in the aftermath of the GFC. For example, such analysis shows that excessively debt
averse ﬁscal policies are self-defeating.13

VI. Ongoing Challenges
Decisive use of central bank balance sheet policies at the onset of the pandemic in
March 2020 resulted in a much better handling of the economic challenges compared
to previous encounters with the ZLB during the past quarter century. It also revealed
the incredible power independent central banks have available during a crisis.
In a low interest rate environment, central banks must be ready to activate the powerof the balance sheet to respond to a crisis and recessionary threats. That said, balance
sheet policies are more challenging for central banks than interest rate policies andraise diﬃcult governance questions. Balance sheet policies are more uncertain andhave more pronounced ﬁscal and distributional eﬀects that can attract political scrutiny
and criticism.
Whenever central banks demonstrate the extraordinary power of their balance
sheets, they risk attracting unwanted attention and controversy, raising the risk ofcompromising their political independence. This is a risk, but one that cannot serve as
an excuse for inaction. Reluctance to employ a central bank’s balance sheet powers to
avoid attracting criticism would constitute an abrogation of responsibility when thesepolicies are needed for meeting the central bank’s core mandate. Central banks must
be ready to activate the power of their balance sheets when needed, regardless of the................................
13. See Hofmann et al. (2021) for pertinent stochastic simulation experiments that focus on the ﬁscal-monetary
policy interactions and the role of QE at the ZLB. A related ﬁnding, presented in Billi and Walsh (2021) isthat a seemingly irresponsible debt-ﬁnanced ﬁscal expansion can be welfare improving at the ZLB.

51

prospect of political scrutiny and criticism and despite perceived risks to their politicalindependence.
Nonetheless, this highlights a challenge: What is the best way to protect the independence and institutional integrity of a central bank after an impressive demonstrationof the power of its balance sheet?
In my view, the answer is simple: Focus attention on the basic central banking
principles that apply regardless of whether balance sheet tools or interest rates are employed. Strive to be apolitical, avoid overstepping the central bank’s core responsibilities and apply the available tools to achieve the central bank’s core objectives. Communicate clearly and adhere to a systematic policy framework that aims to achieve thecentral bank’s inﬂation goal in the medium term.
These principles should be uncontroversial for interest rate policy when the complications associated with ZLB do not apply. The same principles apply to balance
sheet policy, when interest rate policy is hampered by the ZLB. Similar to interest rate
policy, balance sheet policy must be systematic to help ensure that the central bank istransparent, predictable and accountable. The same framework explaining the necessity of the balance sheet expansions observed in response to the pandemic should serve
as a guide for the systematic withdrawal of accommodation that will be appropriate tomaintain price stability once the economy normalizes.
The successful activation of the power of central bank balance sheets in responseto the pandemic was instrumental for fulﬁlling the mandate of central banks as independent institutions. The demonstration of this power also attracted attention to it,highlighting the challenge of maintaining central bank independence. Pursuing a systematic policy that achieves a central bank’s core mandate can protect the central bank’s
institutional integrity and address this challenge.

52 MONETARY AND ECONOMIC STUDIES / NOVEMBER 2021

The Power of Central Bank Balance Sheets

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