Central Banks, Inflation And Taxpayers

Includes: AGG, DIA, QQQ, SPY
by: Evariste Lefeuvre

With the ECB following the FED and the BOE in the extension of the size of its balance sheet, much has been written on the potential risk for taxpayers. The issue might be even more relevant for the ECB given that most of the increase in the size of its balance sheet did not come from Treasury purchases (in spite of the SMP), but from repo operations backed by riskier assets (credit risk is supposedly taken care of by haircuts, but the nature of the CB exposure is different).

“Quasi-fiscal operations” have not only increased the size of the CB balance sheet: they have raised the possibility of incurred losses and the associated recapitalization needs. Two associated questions need to be addressed: does it hamper the CB’s ability to contain inflationary pressures? Is a government bailout necessary? Would it significantly impact fiscal balances and hurt taxpayers?

The traditional view of the relationship between monetary and fiscal authorities is drawn from the “unpleasant arithmetic” model of Sargent and Wallace (1981). The model states that fiscal profligacy can lead to inflation as, given a certain threshold of public debt, monetization will become necessary.

  1. One reason why such a model may not work today is because of the breakdown of the credit multiplier: central monetary base (high powered money) does not translate into loans and (household) deposits as banks hoard cash.
  1. Another is due to the perception bias people many have in regards to the government deficit financing. The 3-year LTROs have provided cash to banks so that they could comply with their bond redemptions. They restored liquidity to the market and eased the funding pressures on fragile banking institutions. It is said that some institutions have also pursued carry strategies (namely using LTROs funds to purchase short- or long-dated sovereign bonds). This implicit funding of the fiscal deficit would be inflationary if it came with higher public spending. But the trend in Europe is a widespread fiscal tightening (in addition, the extent of the phenomena seems limited, as the huge outstanding of overnight deposits at the ECB suggests).

Another inflation risk pertains to the exit strategy. Will CBs remain behind the curve when the economy starts to recover significantly? How long will it take to adjust the balance sheet and soak up excess liquidity? Would any asset sale have a huge impact on yields and kill the recovery?

The Bank of Japan reduced the size of its balance sheet before it started hiking rate in the 2000s. Japan’s experience is only modestly useful for our purposes, as the bulk of public papers on the asset side of its balance sheet were T bills. The natural redemption of the CBs holdings enabled a rapid dwindling of the side of the balance sheet before overnight rates were raised.


  1. We should untangle the management of the CB’s balance sheet from the determination of the targeted level of the repo rate. The reduction of the balance sheet is not necessarily a prerequisite for an increase in the repo rate.
  1. In addition, the risk is not so much the size of the balance sheet as its composition on the liability side. Namely, bank excess reserves are a risk insofar as they can fuel an uncontrolled credit growth. Many CBs can issue short term bonds to soak up liquidity. The FED is not allowed to do so, but the Supplementary Financing Program (SFP) helps Fed implement monetary policy. Under the SFP, the Treasury issues short-term debt and places proceeds in the Supplementary Financing Account , draining deposits from the accounts of depository institutions at the Federal Reserve (read more on how this works).

The problem with quasi-fiscal policy may not be the ability of the CB to deal with inflation, but the losses incurred by the government in case of default (Greece or any sovereign held under the SMP for instance) or fire sales.

Conventional wisdom suggests that those credit losses by a central bank should lead to a recapitalization by the government. Yet, CBs are not commercial banks and there can be a long period of negative equity that does not hamper their operations. I quote here one insightful article on Central Banks negative equity by the SNB Vice Chairman Thomas J. Jordan (who is currently the interim replacement for Hildebrand).

A Central Bank has no liquidity shortage as it can create the necessary liquidity for domestic payments.

A central bank’s ability to continually service its obligations has far-reaching consequences: First, the SNB retains its capacity to act even when it has to report a negative equity position for a short period. ‘Capacity to act’ means that the central bank is fully capable of implementing its monetary policy decisions and carrying out its monetary policy mandate at all times.

Averaged out over the long term, central banks always make profits, which are often referred to as ‘seigniorage’. With these profits, central banks can always rebuild their equity levels after losses. The main reason for their ability to achieve profits is that central banks – unlike private companies – can normally finance their assets virtually for free, thanks to their banknote-issuing privilege.

As a result, an increase in the size of the balance sheet does not necessarily imply inflation in the short run, or incapacity to deal with inflationary pressure in the medium run.

A strong equity base is probably part of the medium run credibility of a central bank, but we should not fear major fiscal consequences from a temporary stretch of negative equity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.