Large central bank balance sheets and market functioning

Report prepared by a Study Group chaired by Lorie Logan (Federal Reserve Bank of New York) and Ulrich Bindseil (European Central Bank).

Central banks expanded their balance sheets on an unprecedented scale in response to the global financial crisis and its aftermath. The scale of these programmes naturally gave rise to concerns about their impact on market functioning, prompting central banks to take steps to mitigate any potential adverse consequences.

This report prepared by a Markets Committee study group reviews the accumulated experience and associated policy implications. It investigates how the design and execution of balance sheet expansion affected market functioning and, in particular, to what extent it affected how market participants could adjust their positions efficiently, and whether asset prices responded to information promptly and reliably. The report complements a parallel study by the Committee on the Global Financial System, which reviews more broadly the effectiveness of unconventional monetary policy tools and the lessons central banks have drawn from their use.

The Markets Committee report notes that some balance sheet-expanding policies were specifically aimed at improving market functioning, and that they delivered on this front. The potential for adverse side effects arose most clearly at a later stage, when asset purchase programmes were introduced to provide monetary stimulus at the effective lower bound for interest rates. But side effects rarely tightened financial conditions in markets to a point that would have undermined policy effectiveness.

 That said, the report finds that some market malfunctioning did arise. In bond markets, adverse effects were mostly associated with asset scarcity, but any such effects were often temporary, in part due to mitigating policies. In money markets, market functioning issues (for example in interbank reserve trading) arose from the abundance of reserves. Yet, other wholesale money markets remained robust and central banks retained sufficient control over short-term rates, typically by introducing new tools. The report acknowledges that prolonged use of large balance sheet policies may have longer-term adverse effects on the market ecosystem, but these are hard to measure at this point.

From the experiences analysed in this report, the report has distilled a set of lessons and best practices. These lessons can help to inform central bankers in minimising negative impacts on market functioning should there ever be a future need to pursue large-scale balance sheet expansion.

JEL classification: E43, E52, E58, G10, G12