Why shrinking central bank balance sheets might be an uphill task
I am thrilled that our paper was invited as part of this year’s Jackson Hole Economic Symposium and presented by Viral Acharya from NYU Stern. Together with Viral, Rahul Chauhan and Raghuram Rajan, we explore possible consequences when central banks start shrinking their balance-sheets. The latter have massively expanded during times of crises and quantitative easing.
The question is: Are liquidity injections and withdrawals simply mirror images? The simple answer is: No!
The reason is what we term “liquidity dependence” and relates to claims created by commercial banks when central banks expand their balance-sheets that are not easily reversible. Let’s explore this in more detail.
Central bank balance-sheet expansion: Indeed, our analysis shows that central bank balance-sheet expansions, or quantitative easing (QE), leads to an almost one-to-one increase in deposits as we would expect. However, we observe an active response by banks: they switch from time to demandable deposits, they shorten the maturity of their deposits (as they have access to sufficient central bank reserves) and they start writing off-balance-sheet credit lines, i.e., future liquidity commitments to firms. In other words: they create claims on liquidity beyond injections by the central bank.
Central bank balance-sheet contraction: Central bank balance-sheet contraction, or quantitative tightening, is NOT simply a reversal of quantitative easing. Demand deposits and credit lines in fact continue to grow even after QE is over; they stabilize to some extent but do not shrink much – if at all – even during quantitative tightening when aggregate reserves are actively shrunk by the central bank. Also deposit maturities do no increase.
One implication is that QE leaves the banking system with financial fragility so that undertaking QT can be an uphill task. Another implication is that liquidity dependence may explain the “dash for cash” during COVID outbreak of March 2020 in spite of reserves being in excess of $1 trillion.
You can find the paper to download here, and the (technical) online appendix here. I hope you find this short summary of our results interesting and please reach out if you have questions.