Bank of England’s Andrew Bailey: The Importance of Central Bank ReservesBankofEngland’sAndrewBailey:TheImportanceofCentralBankReserves

Andrew Bailey, Governor of the Bank of England, was the speaker at the third installment of the PGIM Lecture Series in Honour of Charles Goodhart at the London School of Economics.

Central bank reserves was the topic of Andrew’s presentation. Like other central banks around the world, the Bank of England (BoE) is debating the appropriate path for interest rates after tightening policy in response to higher inflation. Policymakers also face the challenging task of reducing the BoE’s bond holdings while promoting stable markets.

Here are three key takeaways from the lecture:

1. Larger reserves may be necessary to promote financial stability.
   Central bank balance sheets have grown as a result of quantitative easing (QE) that occurred during the global financial crisis and the pandemic. Although central banks such as the BoE and Federal Reserve are reducing the size of their balance sheets from recent levels, the optimal level of reserves to promote financial stability may be higher than the pre-GFC years, although a reduction from recent levels will provide additional “headroom” in the event policymakers need to employ QE in the future.
2. Central banks must thread a middle path.
   There is much debate over whether central banks should return to a small balance sheet—thus relying more on private institutions and markets for liquidity management—or embrace a “new normal.” Bailey said central bankers are beginning to form a consensus that threading a middle path will be the appropriate course. According to Bailey, low levels of central bank reserves and liquidity contributed to the scale of the GFC. Conversely, there is a point at which the costs of an increase in reserve supply would likely outweigh the benefits. The BoE’s Preferred Minimum Range of Reserves (PMRR) provides an estimated range for the minimum reserves to satisfy demand from commercial banks. The most recent assessment falls in the range of £345 billion to £490 billion, while the BoE’s reserves recently stood at approximately £760 billion. Bailey said the BoE may reach the PMRR by the second half of 2025.
3. The BoE must determine the best mix of assets on its balance sheet.
   It remains uncertain what the BoE’s balance sheet will look like once it reaches a steady state. The BoE could hold a portfolio made up of repos (lending reserves against collateral), gilts, or a combination of the two. A key consideration in this decision will be how much interest rate risk the BoE should keep on its balance sheet. Bailey said a repo portfolio would provide the BoE with a reliable and flexible source of reserves, although some challenges remain. The BoE continues to review whether the best way to address these challenges would be through the terms of its facilities alone, or if these challenges support the case for some gilt holdings going forward. In any case, the BoE will likely increase its repo operations in the future—a scenario that market participants should anticipate.