With the US Federal Reserve on its way to bringing its bond-buying programme to an end, many are asking how to return the central bank’s balance sheet to “normal” – that is, to its pre-crisis size and composition. The same debate is under way at other central banks. Should they sell their bonds, or hold on to them until they mature? And if they are going to sell, which securities should go first? Yet there is another question that is equally important but seldom asked: is it sensible to return central banks’ balance sheets to “normal”? There are good reasons not to.
At the beginning of 2007, the Federal Reserve System’s assets totalled $880bn. Today, the balance sheet stands at $4.3tn, including $2.4tn of Treasuries and $1.7tn of mortgage-backed securities. The reason for buying these assets was not to reduce the federal funds rate, which had reached zero by late 2008, but to lower the interest rates at which loans are extended to people and businesses, stimulating demand.
The evidence shows that these bond purchases indeed lowered long-term rates relative to short-term rates, and lowered rates on more-risky compared with less-risky obligations. A conservative estimate is that a $600bn bond purchase (the size of the Fed’s second round of bond buying) lowered long-term interest rates by about 25 basis points: not enormous, but a worthwhile contribution to the US economic recovery. And the effect of lower long-term rates was probably reinforced by higher equity prices and a cheaper dollar.