Central banks have been reinvented over the past decade, first in response to the financial crisis, and then as a consequence of Covid-19. While trying to maintain monetary stability and promote economic recovery, their balance sheets have ballooned. In 2007, the central banks in the US, euro area, UK, and Japan had total assets ranging from 6% to 20% of nominal GDP.1 By the end of 2020, the Fed’s balance sheet was 34% of GDP, the ECB’s 59%, the Bank of England’s 40%, and the Bank of Japan’s 127%.
Before it is possible to consider how well this worked, it is necessary to be clear about what policymakers’ various operations were trying to achieve. Headline declarations of aiming at ‘price stability’ or ‘financial stability’ are unsatisfactory as they jump to end goals without attending to the motivations for specific operations and facilities. The case of the Fed is illustrative. Among other things, they bought US Treasury bonds, offered to purchase commercial paper, corporate and municipal bonds, and set up facilities to lend directly to real economy businesses as well as to securities dealers. These cannot be assessed solely on whether, together or alone, each materially improved the outlook for economic activity and inflation.
Without a sense of the intended purpose of each central bank action, it is difficult for political overseers or interested members of the public to hold central banks accountable. Precisely because central banks are independent (rightly in our view), that accountability takes the form of public scrutiny and debate.2 But we argue that it is also hard for central bankers themselves to do their jobs unless they distinguish carefully – in internal deliberations and external communication – the rationale for different interventions.
After reserve requirements were sidelined in the early-1990s, for years central bankers deployed only two tools: open market operations to help achieve their monetary policy objectives, and discount-window lending facilities to support financial system stability. That changed from mid-2007 in response to two features of modern finance. First, non-bank financial intermediaries – money funds, finance companies, structured finance vehicles, broker-dealers, and the like, accounting for around 30% of private finance in advanced economies – could exhaust their liquidity in ways that wreaked havoc on the real economy. And second, capital markets could seize up when even sound dealers backed off making markets. Central banks found themselves responding to runs both on non-bank intermediaries and in critical financial markets. Then, when Covid-19 hit and governments desperately needed cash to support households and firms, central banks again stepped up. On the way, they substituted themselves for broken, frozen, or sclerotic private markets, and likewise tailored facilities to steer credit to particular sectors or regions.
This is a world far beyond the textbook picture of central banks providing an elastic currency and serving as a 19th century style lender of last resort to sound banks. Consequently, societies need a new vocabulary for discussing what central banks do, and why. Only then is it possible to see whether words and deeds match, and what reforms are needed.
Categorising central bank balance sheet operations and facilities
Commentators, political overseers, and maybe even policymakers themselves are at sea without a framework for making sense of a variety of fundamentally different kinds of balance sheet operations. As a step toward reducing disarray, we propose a five-fold categorisation:
1) Monetary policy: stimulating or dampening aggregate demand to achieve price stability with full use of the economy’s productive resources
2) Lender of last resort: lending funds to fundamentally solvent firms or other collective vehicles facing liquidity needs which cannot be met via private markets
3) Market maker of last resort: addressing liquidity problems in specific markets
4) Selective credit support: steering the flow of credit to specific sectors, regions, or firms
5) Emergency government financing: providing needed funds directly to government.
What is each of these?
Monetary policy (properly understood)
For most people, central banking is synonymous with monetary policy. Central bankers use their balance sheets to set the quantity or price of their money in order to achieve their price stability objectives. In recent years, with policy rates at the effective lower bound, their main instrument shifted from prices (overnight interest rates) to quantities. By purchasing securities, policymakers seek to drive down long-term interest rates and to compress various risk premia, easing financial conditions in an effort to increase aggregate activity and inflation. How well this quantitative easing (QE) works is debatable.3 But, regardless of what we or anyone else might think of its efficacy, bond purchases of this type lie squarely within traditional understandings of monetary policy.
Whether something described as ‘QE’ is always in fact QE as we define it – with the purpose of directly stimulating aggregate spending – is another matter. In fact, bonds might be purchased to keep a market open, fund the issuers (private or public), or finance investors and traders needing to raise cash. So, it is important to distinguish the other types of balance-sheet operations.
Lender of last resort
The lender of last resort (LOLR) stands ready to lend funds to sound firms that are illiquid. This is a form of liquidity re-insurance to financial intermediaries which provide liquidity services to the economy more broadly. Because the central bank has an unlimited capacity to issue money (so long as its liabilities continue to be treated as money), it is the only institution that can take on this role at short notice; a treasury would have to raise resources, perhaps by borrowing from the central bank. The big question is what types of firms should have access to such facilities and on what terms. When banks were the dominant player in the monetary and financial system, lender of last resort facilities were structured for them alone.
Today, there is a set of intermediaries, including broker-dealers, money market funds, and others, that engage in bank-like activities offering demandable liabilities backed by less than completely liquid assets without direct access to the central bank.4 Recent experience suggests they will receive help when they come under stress. For example, the Fed’s liquidity support operations for primary dealers and money market mutual funds clearly fit in this category.
Whatever the merits of different approaches – who has access to liquidity support, and on what terms – central banks should make clear what they are willing to do: a credible, transparent, and explicit regime beats a series of improvisations. If non-banks are to have access, then there should be an open standing facility, but with regulatory constraints. If not, there must be structural reforms to ensure the non-banks will never need to borrow from the central bank and investors do not treat their liabilities as safe.
Market maker of last resort
Market maker of last resort (MMLR) operations are catalytic, aimed at restoring liquidity in a market deemed critical (directly or indirectly) to the real economy.5 With interest rates at zero, market maker of last resort operations to maintain liquidity in government bond markets can look like QE, but they are not. Such actions could occur at any level of the policy rate. Like the lender of last resort, a properly constructed market maker of last resort must have a large capacity but might need to do little. And, if the market maker makes purchases, then they should be unwound once the target market is functioning again. In other words, this is not an investment or term-financing facility. When market maker of last resort purchases are not unwound, the holdings must be serving some other purpose, which requires its own justification.
Examples of market maker of last resort operations are easy to find. The classic is Mario Draghi’s “whatever it takes”, where the ECB provided a backstop for euro area sovereigns but ended up buying nothing. Another is the Bank of England’s 2009 operations in sterling corporate bonds; these were not zero, but small. The Federal Reserve’s Secondary Market Corporate Credit Facilities is a third example. Originally announced on 23 March 2020 and expanded two weeks later, risk spreads and bid-ask spreads shrunk immediately (Gilchrist et al. 2020). While authorisation was for $750 billion, the Fed’s holdings of corporate bonds and exchange-traded funds (ETFs) peaked at $14 billion6 – and could, perhaps, have been smaller.
Selective credit support
Next is selective credit support, which subsidises credit to favoured borrowers in order to steer the allocation of resources in the economy. Policymakers could do this for a variety of reasons, many of which might have a political motive, and so could imply political pressure. Given politicians could be tempted to use the central bank to run targeted programmes, this underlines the need for a clear framework requiring supposedly independent central banks to make public what they are doing and why.
Examples of central banks steering credit to specific sectors, regions, or firms abound. We will mention just two. One is the Eurosystem’s sequence of three targeted longer-term refinancing operations (TLTROs). While complex, euro area national central banks are providing funding at favourable rates (as low as -1%) so long as banks pass it on in the form of loans to businesses or non-mortgage lending to households.7 Another is the Fed’s various programs aimed at providing credit to municipal governments and small businesses.8 In both cases, the central bank is steering credit through a set of both implicit and explicit subsidies. In our view, these are fiscal operations and should be treated as such. In the UK, the government and central bank establish an openly joint Funding for Lending programme, making clear its fiscal element and motivation.
Emergency financing for government
Finally, central banks can use their balance sheets to provide emergency financing to governments. There is a sense in which this brings us back to one of the origins of central banking – war finance. In the current era, to prevent abuse, there are legal restrictions on central banks directly financing government. But since that cannot be excluded in absolutely all circumstances, there should be a framework delineating how and when it may occur, including the central bank’s path back to independence afterwards. If this were in place, it might avoid the need to help government via QE.
Our central point is that these five categories of operation exist, and that countries (or currency areas) need a regime for each one. There needs to be clarity from the central banks themselves in response to the questions “what are you doing, and why exactly are you doing it?”.
Conclusions: This matters!
Over the past 15 years, central banks have been transformed – albeit under some duress given the pre-pandemic passivity of fiscal authorities. Whatever the circumstances, looking at the various uses of the central banks’ balance sheets in recent years, we see significant flaws in the framework governing their actions. Their legal powers may be clear but, except in the case of monetary policy as traditionally understood, we see no regimes that clearly set out purposes, objectives, and constraints. This leaves the public and its representatives without adequate means to scrutinise what their central banks are doing. Further, governance of the different kinds of balance sheet operations nowadays is sometimes uncertain, or fluid. This is true of actions taken as the lender of last resort to non-banks, as the market maker of last resort, as provider of selective credit support, and as backstop banker to government.
Whichever of the five categories of balance sheet operations parliamentarians choose to permit, each must have its own regime while also forming part of a coherent overall framework. On coherence, our view is that the overarching objective for employing any central bank tools should be framed in terms of the stability of the monetary system, and hence the economic function of assets treated as safe. Importantly, however, the validity of our fivefold categorisation does not turn on what we, or anyone else, sees as the fundamental purpose of central banking.
On the design of specific regimes for each permitted type of balance sheet operation, fortunately the existing structures supporting monetary policy (as normally understood) serve as a guide. As a part of each, whenever the central bank acts, the relevant decision-taking body within the central bank should be clear, and it should announce exactly what they are doing and why, with the governor and their relevant colleagues accountable. Doing QE, lender of last resort, market maker of last resort, selective credit support, and emergency government financing all wrapped up together but labelled ‘monetary policy’ would then be less likely.
Altavilla, C, F Barbiero, M Boucinha and L Burion (2020), “The COVID-19 policy response and bank lending”, VoxEU.org, 3 October.
Buiter, W and A Sibert (2007), “The Central Bank as the Market Maker of last Resort: From lender of last resort to market maker of last resort”, VoxEU.org, 13 August.
Cecchetti, S G (2008), “Federal Reserve policy responses to the crisis of 2007-08: A summary”, VoxEU.org, 10 April.
Cecchetti, S G and K L Schoenholtz (2020), “The Fed Goes to War: Part 3”, www.moneyandbanking.com, 12 April.
Gilchrist, S, B Wei, Z Yue and E Zakrajsek (2020), “The Fed Takes on Corporate Credit Risk: An Analysis of the Efficacy of the SMCCF”, CEPR Discussion Paper No. 15258, September.
Kempf, E and Ľ Pástor (2020), “Fifty shades of QE: Central bankers versus academics”, VoxEU.org, 5 October.
Tucker, P M W (2018a), Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, Princeton, N.J.: Princeton University Press.
Tucker, P (2018b), “Unelected power”, VoxEU.org.
1 See Cecchetti (2008) for a summary of the Federal Reserve’s actions in 2007-08.
2 Tucker (2018a) provides a set of principles under which a constitutional democracy can legitimately delegate power to an independent agency staffed by technicians. These include a clear mandate, a reliable set of instruments, constrained powers, transparency, and public debate, and that the agency does not make big distributional choices, which are for elected officials. For a short discussion, see Tucker (2018b).
3 In a recent meta-analysis of research evaluating QE, Kempf and Pastor (2020) conclude that where you stand on this depends on where you sit. Studies by central bank research finds larger effects of QE than do researchers not affiliated with central banks.
4 For different reasons, we would put some open-ended mutual funds and central counterparty clearing houses into this group as well.
5 See Buiter and Sibert (2007) for an early discussion of the market maker of last resort.
7 See Altavilla et al. (2020) for a discussion of the Eurosystem responses to Covid-19.
8 See the discussion in Cecchetti and Schoenholtz (2020).