The Central-Bank Balance Sheet as an Instrument of Monetary Policy

Standard models used for monetary policy analysis “abstract altogether from the central bank’s balance sheet, simply treating a short-term nominal interest rate as if it were under the direct control of the monetary authorities,” which “rules out the kinds of questions that have recently preoccupied central bankers” – the appropriate size of the balance sheet, the composition of its assets, and the interest rate paid on reserves (Introduction, pp. 1-2). The paper’s stated aim is to extend a basic New Keynesian model so that it can explicitly address these questions, rather than assuming them away.

The operating target for the policy rate; the supply of reserves (i.e., the overall size of the balance sheet, jointly with the interest paid on reserves); and the composition of the central bank’s asset holdings (the scale of “credit policy”) (Section 2.3, discussed throughout; explicitly enumerated in Section 3.2, pp. 30-31, in the context of the quantitative-easing irrelevance proposition). A key methodological point is that these three functions of macroeconomic conditions can be specified independently of one another in a general policy-rule framework, and the paper’s central results concern how varying each one, holding the others fixed, affects equilibrium.

Because if assets are valued only for their pecuniary returns and all investors can trade them at the same market prices, any change in the central bank’s portfolio is exactly undone by offsetting private-sector trades, so real allocations are unaffected – “essentially a Modigliani-Miller result,” as noted by Wallace (1981) (Section 1.1, pp. 4-6). The intuition is that the central bank’s earnings (and hence its remittances to the Treasury, and hence taxes) are affected by which risks it holds, so households’ after-tax income remains just as exposed to the underlying risk as if the central bank had not intervened; “the fact that the central bank takes the real-estate risk onto its own balance sheet…does not make the risk disappear from the economy” (p. 5). The authors emphasize the result “does not depend on the existence of a representative household, nor upon the existence of a complete set of financial markets” (p. 5) – it survives arbitrary heterogeneity in risk attitudes, income profiles, and hedging needs, as long as investors can trade freely.

The model replaces the representative household with two types – “borrowers” and “savers,” whose relative impatience to consume evolves as a persistent Markov process – who can only save or borrow through imperfectly competitive financial intermediaries, creating an endogenous credit spread between the borrowing rate and the saving rate (Section 2.1, pp. 11-17). Because the two types’ marginal utilities of expenditure generally differ (summarized by the marginal-utility ratio Ω_t, which equals 1 only under frictionless intermediation), the credit spread affects both aggregate demand, via two separate Euler equations for borrowers and savers, and inflation, via a generalized New Keynesian Phillips curve in which the expected future path of the marginal-utility gap enters alongside expected output – “cost-push effects of credit spreads are taken into account” (p. 17). This friction is what allows the central bank’s choice of which assets to hold, and how much to lend directly to the private sector, to have real consequences that the Wallace-neutrality logic rules out under frictionless markets.

Optimal policy requires that reserves be supplied up to the “satiation” level at which further increases yield no additional reduction in intermediaries’ resource costs or in the equilibrium credit spread – a version of the Friedman Rule – and this satiation condition is equivalent to setting the interest paid on reserves equal to the operating target for the policy rate at all times: i^m_t = i^d_t (Section 3, pp. 26-29, eq. 3.1-3.2). Practically, this means the central bank’s policy committee need not separately deliberate over a reserve-quantity target at each meeting: “once the target for the policy rate is chosen…the quantity of reserves that must be supplied to implement the target can be determined by the bank staff in charge of carrying out the necessary interventions,” on the basis of routine market monitoring (p. 28) – as already practiced by several central banks outside the U.S., such as the Bank of Canada (a fixed 25-basis-point spread) and New Zealand (interest on balances set equal to the policy rate itself).

No: the paper states a formal irrelevance proposition showing that, given fixed rules for the policy-rate target, the interest paid on reserves, and the scale of central-bank lending, the resulting rational-expectations equilibrium for inflation, output, and private credit is independent of the reserve-supply rule, “including…an arbitrary degree of quantitative easing when the zero bound is reached” (Section 3.2, pp. 30-31). This generalizes the corresponding result in Eggertsson and Woodford (2003) to the paper’s model with heterogeneity and credit frictions, and the authors are explicit that it directly contradicts the popular proposal of tying excess-reserve targets to how negative a standard Taylor rule would prescribe: “our result implies that there should be no benefits from such policies” (p. 31). They note two important qualifications: the result applies only when reserve expansion finances additional holdings of Treasury securities (not increased lending to the private sector) and implies no change in expected future interest-rate policy; quantitative easing that instead signals a change in the future policy-rate path, or that finances actual central-bank lending, can have real effects through those separate channels (pp. 31-32).

The authors point to the Bank of Japan’s March 2001-March 2006 quantitative-easing program, which “fits our definition [of pure quantitative easing] fairly closely” since it targeted the monetary base using primarily government securities: despite an eventual 75 percent increase in the monetary base, “nominal GDP never increased at all (relative to its March 2001 level) during the entire five years of the policy,” and studies finding any reduction in longer-term rates during the episode attribute it mainly to signaling about future rate policy, not to the reserve expansion itself (Section 3.2, pp. 32-33). By contrast, they cite the Federal Reserve’s Commercial Paper Funding Facility, introduced in October 2008, as evidence that targeted purchases can matter: spreads on the specific categories of commercial paper eligible for purchase fell sharply after the facility’s introduction, while the spread on an ineligible category (A2/P2 paper) “remained high for several more months” – a pattern the authors read as evidence that targeted asset purchases, unlike pure reserve expansion, did move market prices (Section 1.3, pp. 10-11).

Credit policy is irrelevant under the same frictionless-market conditions that make balance-sheet composition generally irrelevant, but once private intermediation is imperfect (modeled here via an increasing marginal cost of private lending), central-bank lending to the private sector can lower the equilibrium credit spread and raise welfare by substituting, at the margin, for scarce private intermediation capacity (Section 4, pp. 34-40). Using a calibrated numerical version of the model (parameters in Table 1, largely drawn from Cúrdia and Woodford 2009a and Rotemberg and Woodford 1997), the authors show that active credit policy has positive value in response to several types of financial disturbances, and that “optimal interest-rate policy reduces at least slightly the welfare gain from active credit policy” (Section 4.2, p. 50) – i.e., credit policy and conventional interest-rate policy are partial substitutes, but do not fully substitute for one another.

Because different underlying disturbances that produce similar observed increases in the credit spread imply different optimal scales and durations of central-bank lending: the paper distinguishes a “multiplicative Ξ” shock (a rise in the resource cost of private intermediation) from an “additive χ” shock (a rise in expected loan defaults), and shows numerically that “even when the zero lower bound binds and interest-rate policy can be described by a Taylor rule, the size of the increase in credit spreads alone provides insufficient information to judge” the appropriate policy response (Section 5, pp. 58-59, discussing Figures 7 and 12). The practical implication is that a central bank cannot mechanically calibrate credit-policy intervention to the observed size of spread movements; it needs some view about what is actually driving the disruption in a particular credit market.

When a financial disturbance is large enough to push the policy rate to its zero lower bound, the marginal social benefit of central-bank credit policy rises, because the usual interest-rate channel for absorbing the shock is unavailable: in the paper’s calibration, “under each of the four types of financial disturbance that are considered, it will be optimal for the central bank to lend to private borrowers, at least in the first two quarters, even if the marginal cost of central-bank lending is as high as 10 percentage points per annum” once the disturbance is large enough to bind the zero bound under a Taylor rule (Section 4.2, pp. 49-50). The authors are careful, however, that reaching the zero bound is “neither necessary nor sufficient for active credit policy to be welfare-improving” (Conclusions, p. 61) – it raises the stakes of the credit-market-specific judgment described in Q9, rather than replacing it.

No – because the interest rate paid on reserves can be set independently of the policy-rate target and of the quantity of reserves outstanding, “there is no need to balance the benefits of [credit] policy for the efficiency of financial intermediation against any supposed inflationary threat inherent in the increased size of the central bank’s balance sheet,” since paying interest on reserves “can make even a large quantity of excess reserves consistent with high short-term interest rates” (Conclusions, p. 61). The authors draw out the practical implication for exit strategy explicitly: “there is no reason that the timing of the Fed’s reduction in its holdings of assets other than short-term Treasuries must be tied in some mechanical way to the timing of a decision to raise the federal funds rate,” since the two decisions rest on different considerations – credit-market-specific conditions for the former, macroeconomic stabilization goals for the latter (Conclusions, p. 62).

The authors stress that their irrelevance result for quantitative easing depends on specific modeling assumptions – “different results might be obtained under alternative theoretical assumptions” – and that they lean on the Bank of Japan’s experience mainly because it seems consistent with the theory, not as independent proof of it (Conclusions, p. 60). They are similarly cautious about credit policy: even where it is welfare-improving in principle, “one must be cautious in drawing conclusions about the welfare consequences of credit policy” from the mere size of an observed spread increase, and “the appropriateness of active credit policy is likely to depend on conditions that are specific to the markets for particular financial instruments, and that therefore cannot be assessed on the basis of macroeconomic conditions alone” (Conclusions, pp. 60-61).