Tuomas Välimäki: What is the optimal size of central bank balance
sheets?
Introductory remarks by Mr Tuomas Välimäki, Board Member of the Bank of Finland, at
the OMFIF seminar " The New Era of Central Bank Policy and Operations", Frankfurt
am Main, 19 March 2023.
* * *
Introductory remarks of the session on Navigating quantitative
tightening
First, I would like to thank the organizers for inviting me here today to discuss a topic
close to my heart: monetary policy implementation. The timing for this discussion is
excellent, as last week the ECB Governing Council took some important decisions on
the way forward on this frontier. Not only did it make this subject extremely topical, but
had the preparation still been ongoing, I believe it would have been simply impossible
for me to participate in this event.
Now, I will briefly introduce the basic logic behind my thinking on one of the topics of
this session: the natural size of central bank balance sheet. In addition, as the
Eurosystem's current balance sheet seemingly exceeds its natural size, I will reflect my
views on the future path for the balance sheet: Does our original thinking still stand after
some 25 years.
The fundamental building blocks of a central bank balance sheet result from the core
tasks pledged to the central bank itself. In addition to maintaining price stability and
supporting financial stability, these tasks often include functions like the issuing of
banknotes as well as holding the country's official foreign currency reserves. These
elements are also the ones that determine the natural size of the central bank balance
sheet. As they are not directly related to the making of monetary policy, we often call
them autonomous liquidity factors, and take their developments as given.
In a large economy that issues a reserve currency, the demand for banknotes is likely
to exceed the level of foreign reserve holdings needed. In such a case, the autonomous
central bank liabilities tend to exceed assets, and so, the liability side determines the
size of the balance sheet. This is certainly the case for the Eurosystem. The demand for
euro cash is currently more than 1 500 billion euros, whereas the level of FX holdings is
1
less than 300 billion euros. The case is even clearer, if one takes into account that we
have always asked banks to hold minimum reserves with the Eurosystem, the public
sector is allowed to hold deposits with National Central Banks and some foreign central
banks hold part of their euro reserves with the Eurosystem.
Based on this, I would conclude that the liability side dominates the determination of the
natural size of the Eurosystem balance sheet size. Thus, it would be natural for the euro
area banking sector to operate in a liquidity deficit, and for the Eurosystem to cover this
structural liquidity gap by providing central bank reserves with its monetary policy
instruments. Accordingly, originally the Main Refinancing Operations were used as the
marginal tool for liquidity provision, and the MRO rate was setting the starting point of
the euro yield curve. This framework lasted until the global financial crisis.
Now, even if we can derive rather easily this kind of a natural starting point for the
central bank balance sheet, it is not the end of the story. Natural balance sheet size
does not need to equal its optimal size. From time to time, the quest for price stability
and the need to facilitate financial stability, may call the central bank to make
nonstandard monetary policy interventions, resulting in liquidity provision beyond the
structural liquidity needs of the banking sector. In such a case, at some point, the asset
side starts to dominate the size of the balance sheet, and the rate at which the excess
liquidity is drained becomes the instrument for setting the interest rates.
This has been, as you well know, the case for the Eurosystem for a decade or so. First
to address the risk of entering into a deflationary spiral, and then to address the
financial stability concerns posed by the pandemic, the Governing Council engaged in
large scale asset purchases. Accordingly, for more than a decade now, the asset side
has dominated our balance sheet, and we've been steering money market rates with
the rate applied to banks' deposits with us.
The switching from liquidity provision to draining it, was not a deliberate decision based
on monetary policy implementation aspects nor the optimal balance sheet structure.
Monetary policy implementation changed fundamentally as the world around us
changed, requiring monetary policy responses that strongly shaped our balance sheet.
The need to guarantee financial stability when the global economy is being hit by a
pandemic clearly increased the optimal central bank balance sheet to levels
significantly larger than the natural size would imply.
Now that those forces are no longer prevailing, we've been able to return to setting
monetary policy stance with our standard tool (interest rates), and to scale back the
extraordinary provision of credit to banks. This has been an opportune moment for us to
reconsider, what type of monetary policy implementation framework suits best for the
Eurosystem in the longer run.
As a result of our framework review, the Eurosystem will move back towards a system
in which marginal liquidity is eventually supplied through short-term credit operations at
a fixed rate and with full allotment procedure. Hence, the new framework can be seen
as a move from a supply-driven balance sheet towards a demand-driven one. In some
sense, this marks a natural return towards our original thinking that led us to design a
demand-driven system based on refinancing operations, and a liability driven balance
sheet.
We have started a journey to normalize our balance sheet, but its size will be different
from what it was before the series of crises started some 15 years ago. The natural size
of our balance sheet has doubled thanks to the increase in the autonomous liquidity
factors. Furthermore, we will continue meeting the banks' demand for reserves in full
also in the future. Hence, this demand will be an important driver of the overall amount
of liquidity and thus also the size of the central bank balance sheet. Yet, even if there
are uncertainties in the way, our direction is clear, we will be unwinding the legacy
monetary policy outright portfolios, and this process will take quite some time before we
introduce new ways to provide the banks with their structural liquidity needs.
As there are many uncertainties around the monetary policy implementation landscape
today, we must stand ready to react and calibrate the size and composition of our
balance sheet also in the future if and when monetary policy does not transmit
smoothly. After all, monetary policy operational framework needs always to serve our
monetary policy ultimate goals - price and financial stability needs will always dominate
in our thinking about the optimal balance sheet. So, in the Eurosystem, we will carefully
monitor the evolution of all the relevant markets and indicators and stand ready to
adjust the framework design and parameters if necessary.
Thank you for your attention. I am looking forward to our discussions in which we may
dig deeper into the design of central bank operational frameworks.
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One could add Gold and IMF receivables to the natural central bank assets, but when
netted with their liability side counterparts (revaluation accounts and IMF Special
Drawing rights), their volume would not change the big picture.