SPEECH
SVERIGES RIKSBANK
DATE:
13/04/2018
SE-103 37 Stockholm
SPEAKER: (Brunkebergstorg 11)
Martin Flodén
VENUE:
Swedish House of Finance
Tel +46 8 787 00 00
Fax +46 8 21 05 31
registratorn@riksbank.se
www.riksbank.se
The Riksbank's balance sheet: How large
should it be in the future?*
Prior to the financial crisis, the Riksbank had a balance sheet of about SEK 200
billion. It now amounts to SEK 870 billion. The balance sheet has thus risen from 6
per cent to 20 per cent of GDP (see figure 1). This recent growth in the balance
sheet is an experience we share with many other central banks. It is primarily a
result of central banks having complemented low interest rate policy with asset
purchases in order to make monetary policy even more expansionary.
This expansionary monetary policy has had an impact and helped strengthen the
economy as well as push up inflation to levels that are compatible with the
inflation target. In Sweden, we are therefore approaching a situation where the
monetary policy expansion can start to be tapered and the interest rate and balance
sheet can start to be normalised. But what will monetary policy actually look like
in a future "normal situation"? This is currently a subject of intense discussion
among many central banks and other agents. Analyses by the Riksbank and others
indicate that average interest rates in the future will be lower than what was
deemed normal in the decades before the financial crisis.1 But what are we to
expect from the Riksbank's balance sheet in the future? This is the question I would
like to discuss today.
My discussion will be based on a monetary policy perspective, which means that
the focus is on the holdings of Swedish government bonds built up by the
Riksbank in recent years and on the monetary base and the liquidity surplus that is
now on the liability side of the balance sheet. There are other components that
also have a major impact on the Riksbank's balance sheet but I will not discuss
these in any particular detail. Here, I am thinking mainly about the foreign
exchange reserve.
I will also refer to the international discussion, in which arguments have been put
forward both for and against "large" central bank balance sheets. The arguments
concern two related questions: Should the purchase and sale of bonds be an
active monetary policy tool even in the future? Do large bond holdings strengthen
the transmission of central bank policy rates to market rates?
Before I analyse these questions in more detail, I would like provide some
background by describing both what central bank balance sheets looked like before
the crisis and how they have developed since, and how the design of monetary
policy interacts with the balance sheet. This background is important in order to
be able to assess how the Riksbank's balance sheet should develop over the
longer term and be able to relate to the discussion in other countries. Central
bank balance sheets were quite different prior to the financial crisis, both in
composition and size. We can expect countries in which monetary policy steers
towards similar future inflation targets to have comparable interest rate levels. The
balance sheets may, however, look quite different.
My main message today is that the monetary policy arguments for a large balance
sheet are, in my opinion, not particularly strong in the Swedish context. Indeed,
there are also risks associated with maintaining a large balance sheet. The most
likely scenario is therefore that the Riksbank's balance sheet will, in a future
normal situation, be substantially smaller than it is today.
There is no "normal" balance sheet
Figure 2 shows what various central bank balance sheets looked like just over a
decade ago, prior to the global financial crisis. The most striking feature of the
figure is that balance sheets looked different in different countries.
In some countries, for example the United States and Canada, the central bank
had a lean balance sheet, the size of which was determined in practice by the
demand for banknotes in the economy. The asset side was dominated by domestic
government bonds while the liability side was dominated by issued banknotes.
These lean balance sheets meant that they had an almost entirely risk-free
financial position as the central bank receives interest payments on the assets while
the liabilities are cost-free. In this way and if the interest rate is sufficiently high
and the banknote demand sufficiently large, the central bank can fund its own
operations and deliver a surplus to the state.
The Riksbank and the Swiss National Bank also had relatively minimalistic balance
sheets where the liability side was dominated by cost-free capital, but, apart from
banknotes, these central banks had accumulated equity on the liability side. The
asset side was dominated by gold and foreign exchange reserves, and the
Riksbank held no government bonds at all. Despite these similarities, the Swiss
National Bank had a significantly larger balance sheet than the Riksbank. This was
due to both a substantially higher demand for cash in Switzerland and the fact
that the Swiss National Bank had more equity.
In other countries, such as Japan and New Zealand, central banks had balance
sheets that were larger than was justified by the cost-free capital. The Bank of
Japan had already implemented quantitative easing before to the financial crisis in
order to bring up inflation. As a consequence of this, Japanese banks had liquidity
reserves on the central bank balance sheet. The Reserve Bank of New Zealand had
a balance sheet with several large items on the liability side. There were deposits
from both banks and the state, as well as currency loans which funded some of
the country's foreign exchange reserve.
There are several explanations why the balance sheets looked different in
different countries. To a certain extent, it depends on the monetary policy regime. For
example, the need to maintain a foreign exchange reserve may depend on
whether the country has a fixed or floating exchange rate. To a certain extent, it
depends on history and previous monetary policy regimes. The size of the gold
reserve can often be explained by previous links between the currency and the gold,
and the currency reserve can be a remnant from previous regimes with a fixed
exchange rate. The way the balance sheet looks is also influenced by what tasks the
central bank has and how profits and risks are distributed between the bank and
its owners.2
Figure 3 shows that many central bank balance sheets, including the Riksbank's,
have grown rapidly after the financial crisis. But how will the balance sheet
develop when monetary policy is normalised? Should central banks strive for a lean
balance sheet or is there reason to let balance sheets remain large? This review
shows that there is no "normal" balance sheet that can be seen as an obvious
benchmark. The development will instead be determined by central banks'
analysis of, for example, how the size and composition of the balance sheet interact
with interest rate policy in normal times.
The interest rate level does not affect the Riksbank's
balance sheet
According to traditional textbook models, the central bank steers the short-term
interest rate by buying and selling securities in order to expand or contract the
money supply, known as "open market operations". The basic premise is that
commercial banks that receive deposits from households must keep a certain
amount of liquid funds to be able to serve customers wishing to withdraw money
from their accounts. These liquid funds constitute the monetary base of the
economy and can consist of either banknotes in the banks' cash vaults or reserves held
by the banks in non-remunerated accounts at the central bank.
When the market rate is positive, the banks lose money as they are obliged to
maintain liquidity reserves, and the higher the interest rate is, the less willing the
banks are to maintain reserves. According to this textbook model, there is
therefore a directly negative correlation between the size of the monetary base and the
level of the interest rate. The central bank can conduct monetary policy either by
setting an interest rate and letting the monetary base adapt to it, or by
determining the size of the monetary base and thereby let the interest rate adjust itself.
Up until the outbreak of the financial crisis, the textbook model was quite an
applicable description of monetary policy in the United States. The Federal Reserve
took a decision on a policy rate and then implemented it in the form of open
market operations that increased or decreased the volume of reserves the banks held
in accounts at the central bank until the market rate coincided with the decided
interest rate level.
It is a long time, however, since the textbook model was an applicable description
of monetary policy in Sweden.3 There is little cash use and the cash reserves of
commercial banks are therefore only negligible. Furthermore, there is no
requirement in Sweden for commercial banks to hold liquidity at the Riksbank in
proportion to their deposits.4 Put simply, one can say that there is no monetary base in
Sweden.5 In other words, the Riksbank does not conduct monetary policy by
changing "the amount of money" in the economy. Instead, the Riksbank
determines "the price of money" by directly setting the interest rate on certain
financial assets.6 These assets are either deposits or lending from the Riksbank to
commercial banks depending on how much liquidity there is in the system.
If there is a surplus of liquidity in the economy, banks will have credit balances on
the Riksbank's balance sheet in the same way as when they are forced to hold
liquidity reserves in accordance with the textbook model. The major difference
from the textbook model is that the Riksbank pays the market rate on the
reserves.7 Accordingly, the link between monetary base and size of the central bank
balance sheet and the interest rate has also been broken; bank reserves are
remunerated at the market rate and the Riksbank can thereby determine the interest
rate irrespective of how large the liquidity reserves in the economy are.8
The repo rate is the main monetary policy tool ...
When, in the initial stages of the financial crisis 2008-2009, policy rates had been
lowered to levels close to zero, there was a need for further monetary policy
expansion in several parts of the world. Central banks like the Federal Reserve and
the Bank of England bought large quantities of bonds. The aim of these purchases
was both to push down the general level of interest rates and to support some
sub-markets that functioned poorly during the crisis, for example the market for
mortgage bonds in the United States. In the euro area and in Sweden, central
banks began similar purchasing programmes a few years later.
The theoretical support for the claim that bond purchases make monetary policy
more expansionary is quite weak and controversial. In spite of the weak
theoretical support, many argue that the experiences of bond purchases are good.9 Some
even say that the bond purchases have worked so well that they should remain
part of the monetary policy toolbox even in normal times.10 This is a conclusion I
find rash, at least as far as the Riksbank is concerned.
The fact that bond purchases seem to have worked well in certain situations and
countries does not mean that they will work well in normal times. To draw that
conclusion, one needs to consider how bond purchases may have contributed to
making monetary policy more expansionary. There are at least four different ways
that are usually mentioned. First, the purchases may have functioned as a market
stabiliser during the most acute phases of the financial crisis when the markets
functioned poorly. The asset purchases then helped to keep the pricing of bonds
going and to push down interest rates.
Second, it may have been a question of risk transfer. This is when the central bank
purchases private assets (e.g. mortgage bonds) so that the market risk for these
assets is transferred to the public balance sheet, or similarly when a central bank
in a currency union purchases government bonds from countries with different
credit risks. Even in this case, market prices can be maintained so that some
market rates are pushed down despite the monetary policy interest rate not being
lowered.
Third, bond purchases can be a way of influencing expectations of future policy
rates. The central bank loses money if it raises the policy rate after it has
purchased bonds with long maturities. Bond purchases can therefore make it more
credible that the central bank will keep the policy rate low going forward. This
would cause the market rates for bonds with long maturities to fall.
Fourth, bond purchases can affect yields at different maturities through a
socalled portfolio balance channel. This occurs if market participants don't see
short-term deposits at the central bank as a perfect substitute for the government
bonds they have sold to the central bank. The purchasing of long-term
government bonds by central banks reduces the supply of safe assets with long
maturities, which drives up the price and drives down yields on long-term government
bonds.11
I find it difficult to believe, however, that these channels will be particularly
effective in the Swedish economy in a future environment of more normal monetary
policy.
As I have said previously (Flodén, 2015), I also suspect that the effects via these
channels have not been particularly strong in recent years, as the Riksbank has
purchased large volumes of bonds. The Riksbank's purchases have taken place in
an environment where the markets are well-functioning. Furthermore, the
purchases have only been of government bonds, which have the same risk profile as
the certificates issued by the Riksbank to fund the purchases. In addition, the
portfolio balance channel has been partly rendered inoperative as a result of the
Swedish National Debt Office's repo facility, where market participants can
borrow an unlimited amount of government bonds with the desired maturity.
I think that the positive effects of the Riksbank's bond purchases have instead
been mainly achieved in another way. When the Debt Office's dealers make use of
the repo facility and borrow bonds, it is done at an overnight interest rate that is
0.40 percentage points below the Riksbank's repo rate. As the Riksbank's holdings
of government bonds have increased, the short-term market rates for
government securities have therefore been pushed down towards -0.90 per cent, i.e. the
repo rate minus the cost for the facility (see Figure 4). Via expectations, the low
level of these short-term rates has then also pushed down yields on long-term
government bonds.12
In practice, there are hence two levels on the money market in Sweden, one
around the repo rate and one around the cost for the National Debt Office's
facility. My assessment is that an equally expansionary monetary policy could in
principle have been achieved without quantitative easing but with a repo rate
somewhere between these two interest rate levels. In recent years, setting a lower
repo rate could have been problematic but in a future scenario with more normal
interest rate levels, I see no need to try to affect short-term market rates with
tools other than the repo rate.
And as regards the formation of expectations and the transmission from
shortterm rates to rates on longer maturities, the Riksbank has a long tradition of using
transparent communication to signal future monetary policy plans, for example by
publishing forecasts of the repo rate's development.13 If it is considered important
to influence market expectations in a certain way, I believe that it is normally
easier to achieve this using well-considered communication, for example in the form
of more or less forceful statements from the Executive Board about future
interest rate policy, rather than in the form of bond purchases.
... but increased likelihood of unconventional monetary
policy in times of economic slowdown
When the acute phases of the financial crisis began in the autumn of 2008, the
Riksbank owned no domestic bonds. As a result, the Riksbank found it difficult to
quickly intervene on the market with appropriate support measures. A lesson
learnt from this episode was that the Riksbank needed to have preparedness in
order to be able to act on the bond market in special situations. Such
preparedness presupposes that the Riksbank maintains at least a small portfolio of
government bonds in order to have the necessary systems, agreements and knowledge
in place. The Riksbank therefore built up a government bond portfolio in 2012-
2013.14
This justification for maintaining a bond portfolio is still relevant. A future
reduction of the Riksbank's bond holdings will therefore most likely not result in a
complete phasing out of the portfolio. But the bond portfolio built up in 2012-2013
was small in relation to the one built up for monetary policy purposes. Bond
purchases in 2012-2013 totalled SEK 10 billion, compared with purchases for
monetary policy purposes since 2015 totalling more than SEK 300 billion.
The support measures that may become relevant in special situations can either
relate to market stabilisation, as was the case in the autumn of 2008, or to bond
purchases as a complement to monetary policy when the policy rate is restricted
by its lower bound.
There is a great deal to suggest that real interest rates in Sweden and abroad will
be lower in the future than they were during the decades preceding the financial
crisis, partly as a result of demographic changes and a new saving pattern in the
global economy.15 As a consequence, several central banks, including the
Riksbank, have revised down their assessments of what is a normal level for the policy
rate. The likelihood is therefore greater than we will touch the lower bound for
the repo rate in the event of economic slowdown. This means that we in the
future more often may need to use bond purchases as a complement to the repo
rate and repo rate forecast.
So, even if I have argued that a portfolio of government bonds has a limited role
to play in monetary policy in normal conditions, I nevertheless expect that the
Riksbank, along with other central banks, will find itself in situations where bond
purchases are justified as a complement to interest rate policy.
Other arguments for a large bond holding
The arguments for large bond holdings in normal circumstances that I have so far
discussed seem not to be particularly relevant to the Riksbank's monetary policy in
a future normal situation.
Another argument put forward by some is that a large bond holding, and thereby a
larger liquidity surplus in the economy, may strengthen the monetary policy
transmission mechanism.16 The arguments basically say that a liquidity surplus - when
the banking system has plenty of central bank reserves - can mitigate the risk of
frictions on the money market. During the financial crisis, the interbank market
functioned poorly, causing market rates to become more volatile and making it
more difficult for financial institutions with no direct access to central bank facilities
to get access to liquidity. With a large liquidity surplus, the economy becomes less
dependent on a well-functioning interbank market.
Regardless of the soundness of these arguments, they have no implications for the
Riksbank's bond holdings. The fact is that the liquidity surplus in Sweden will, in all
likelihood, be large irrespective of how the bond portfolio develops in the future.
We already had a structural liquidity surplus in the economy before the Riksbank
began its bond purchases in 2015, and the surplus has increased since then as a
result of reduced cash use and the Riksbank's dividend payments. The Riksbank's
bond holdings now amount to SEK 363 billion while the liquidity surplus, i.e.
commercial banks' claims on the Riksbank, amounts to SEK 435 billion. The liquidity
surplus would therefore be about SEK 70 billion even if the entire bond portfolio was
sold.17
Another argument sometimes put forward in favour of large bond holdings is that
the central bank's purchases would increase the supply of safe assets in the
economy, and that there is otherwise a shortage of such assets.18 The Riksbank's bond
purchases result in that government bonds with a specific maturity disappear from
the market and are replaced by Riksbank certificates with a maturity of one week.19
The Riksbank then takes over some of the maturity transformation that the market
otherwise tries to achieve on its own, and helps to reduce the interest rate risk in
the outstanding portfolio of government securities. This argument isn't particularly
convincing either. If it is considered important to have short maturity on the
national debt in normal times, this should be dealt with when the government bonds
are issued, and it is then a question for the National Debt Office.
Furthermore, the conversion from government securities to Riksbank assets does
not seem to increase the supply of safe assets in Sweden; the interest rate on
(short-term) government securities is lower than the repo rate which means that
the market price of government bonds is higher than the price of Riksbank
certificates with the same maturity. This pricing indicates, if anything, that the market
prefers to hold government bonds rather than central bank reserves and hence that
the Riksbank's bond purchases are reducing the supply of the safest assets.
Another indication of this is that the term premiums on government bonds have been
very low, and probably negative, in recent years.20 This suggests that government
bonds with long maturities are not being priced with risk premiums in relation to
Riksbank certificates or government securities with short maturities.
I have now discussed arguments that could indicate that the Riksbank should
continue to maintain a large portfolio even in the future, and I don't consider these
arguments to be particularly strong. But does this mean that the size of the balance
sheet has no significance or are there strong arguments indicating that the
Riksbank's balance sheet should be small?
Arguments against substantial bond holdings in normal
times
Maintaining a large balance sheet can be associated with risks, but the nature of
these risks depends both on the assets held by the central banks and how these
are funded on the liability side. The risks may relate to the central bank's financial
position and ability to conduct monetary policy and simultaneously fund its own
operations, as well as to its reputation and possibility to safeguard its
independence in monetary policy issues.
Plosser (2018) discusses risks to reputation and argues that the central bank must
have a narrow mandate to be able to justify continued independence from the
political sphere. The risks he discusses are mainly linked to central banks that buy
assets other than government bonds. The more the central bank involves itself in
risk and capital allocation in the economy, the greater the risk of it being exposed
to political pressure with respect to how it should conduct its policy. And more
generally, the larger the central bank's balance sheet, the greater the risk of
politicians wishing to utilise the resources in a specific way.
Plosser's arguments are important, but they are not particularly applicable to the
Riksbank's current situation. The Riksbank has only purchased government bonds,
and we have spread our purchases fairly evenly on the outstanding bond stock in
order to affect the general level of interest rates rather than specific bond prices.
And despite the Riksbank's balance sheet having grown rapidly in recent years, it
is significantly smaller in relation to GDP than in many other countries.
As far as the Riksbank is concerned, I consider the financial risks to be more
problematic. The large bond portfolio means that the interest rate risk on the balance
sheet has increased. The bonds we have purchased have an average maturity of 5
years, but are funded with Riksbank certificates with a maturity of one week. If
the interest rate rises, the funding costs will therefore increase while the return
on the bonds already purchases remains unchanged. In addition, the expected
return on the Riksbank's bond portfolio is low. This is due partly to term premiums
being generally depressed in recent years, and partly to the return on government
bonds being, so to speak, based on the interest rate in the National Debt Office's
facility (i.e. 0.40 percentage points below the repo rate) while the funding costs
are based on the repo rate.
Central banks can normally fund their own operations and conduct an
independent monetary policy using the return on their cost-free capital, i.e. the assets they
hold that correspond to the cost-free liabilities. These liabilities consist of the
volume of banknotes in the economy and the central bank's equity.
Compared with other central banks, the conditions for the Riksbank to bear risk
are less favourable. This is because cash use is limited and, as a result, the volume
of banknotes only amounts to about one per cent of GDP, compared with around
10 per cent in the euro area, the United States and Switzerland, and almost 20 per
cent in Japan. Admittedly, the Riksbank's equity is greater than that of central
banks in certain other, mostly Anglo-Saxon, countries. But the overall picture is
nevertheless that the Riksbank has less cost-free capital than other central banks
and hence the conditions for holding financial risk on its balance sheet are less
favourable (see Figure 5). This picture has been reinforced in recent years as the
volume of banknotes has rapidly declined. Furthermore, the earning capacity of
all central banks has weakened as underlying interest rates have fallen.21
I have previously discussed the financial risks that occur on the Riksbank's balance
sheet when we have large bond holdings.22 These risks in combination with the
Riksbank's weak earning capacity constitute an argument in favour of a smaller
balance sheet in the long run. This is the best way of safeguarding the Riksbank's
future capacity to fund its own operations and conduct an independent monetary
policy.23
Reasonable for the Riksbank's balance sheet to shrink
in the long run
The Riksbank's balance sheet has grown rapidly in recent years, partly because we
have purchased government bonds for monetary policy purposes, and partly
because the foreign exchange reserve has been strengthened.
In other countries, arguments have been put forward indicating that central banks
should perhaps continue to hold large bond holdings even in the future when
monetary policy has been normalised. In my opinion, these arguments are of
limited relevance to Sweden and the Riksbank.
On the other hand, there are arguments indicating that the Riksbank should
mitigate its financial risk by winding down most of its bond holdings when monetary
policy is normalized. My assessment is that the best way of winding down the
bond holdings with as little market influence as possible is to hold the bonds in
the portfolio until they mature. Over the next decade, the Riksbank's bond
holdings will then develop approximately as shown in Figure 6.
The repo rate and the rate path will thus be the main monetary policy tools when
monetary policy has been normalized. But normal interest rates appear to be
lower than previously thought. It is therefore more likely that we touch the lower
bound for the repo rate in times of economic recessions, and we may then again
need to use bond purchases as a complement in monetary policy.
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can government bond purchases make monetary policy more expansionary?",
Economic Commentaries No. 12, Sveriges Riksbank
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programmes and financial markets: lessons from the euro area", ECB Working Paper
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No 71, Bank for International Settlement
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2 september
Blinder, Alan, Michael Ehrmann, Jakob de Haan and David-Jan Jansen (2017),
"Necessity as the mother of invention: monetary policy after the crisis", Economic
Policy 32, 707-755
Costancio, Vitor (2017), "The future of monetary policy frameworks", speech, 25
May, European Central Bank
De Rezende, Rafael B., David Kjellberg and Oskar Tysklind (2015), "Effects of the
Riksbank's government bond purchases on financial prices", Economic
Commentaries No. 13, Sveriges Riksbank.
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Fed's new policy setting", Jackson Hole Symposium, Federal Reserve Bank of
Kansas City
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2015, in Sveriges Riksbank (2015), Minutes of the monetary policy meeting,
February 2015
Flodén, Martin (2016), "The Riksbank's bond purchases affect government
finances", speech, 9 November, Sveriges Riksbank
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Figures
Figure 1. The Riksbank balance sheet, 2006 and 2017
20 20
Other
Other
Equity
16 16
Government bonds
12 12
Bank reserves
Gold
8 8
Lending to banks
Other
Other
Coins and notes
Gold
Equity
FX Reserve
4 4
Coins and notes
FX Reserve FX Debt
FX Debt
0 0
Assets Liabilities Assets Liabilities
2006 2017
Note. Per cent of GDP
Sources: Statistics Sweden and the Riksbank
Figure 2. Central bank balance sheets before the financial crisis
Note. Per cent of GDP. Refers to 2006. The breakdown into asset and liability classes should be seen
as indicative
Sources: Respective central bank and national statistics sources
Figure 3. Central bank balance sheet totals, 2006 and 2017
140 140
2006 2017
120 120
100 100
80 80
60 60
40 40
20 20
0 0
RB Fed ECB SNB
Note. Per cent of GDP
Sources: Respective central bank and national statistics sources
Figure 4. Two levels of short-term interest rates
1.0 1.0
Average interest rates in the repo market for government bonds
Treasury bill, 3 months
Forward rate, 3 month