Central Bank Balance Sheet Expansion and Financial Stability: Why Less Can Be MoreCentralBankBalanceSheetExpansionandFinancialStability:WhyLessCanBeMore

Raghuram Rajan, former Governor of the Reserve Bank of India and a professor of finance at Chicago Booth, was the speaker at the second installment of the PGIM Lecture Series in Honour of Charles Goodhart at the London School of Economics.

In his presentation, Rajan discusses the reaction function of monetary policy actions and whether central banks risk upsetting financial stability through phases of quantitative easing (QE) and quantitative tightening (QT). Here are three key takeaways from the lecture:  

1) Don’t forget the reaction function: Goodhart’s law—named after economist Charles Goodhart—states that statistical regularities will collapse when pressure is placed on them for control purposes. Rajan notes that the effects of quantitative easing not only include the expansion of the central bank’s balance sheet, but also the expansion of commercial banks’ balance sheets. This reaction function leads to a fairly stretched system as banks consume all of the liquidity provided by the central bank—and then some. As banks’ reserves grow, firms tend to issue more demand deposits and lines of credit. This domino effect can lead to unintended consequences when financial conditions tighten, as a decline in reserves potentially creates illiquidity in the system. Following sweeping stimulus programs to stabilisze markets during the early stages of the COVID-19 pandemic, central banks began to tighten policy to counter inflation. The UK financial system came under stress due to a rapid climb in gilt yields, while US regional banks felt pressure from rate increases and a liquidity squeeze.

2) Heed lessons from the bank turmoil: A recent example of monetary policy’s unintended consequences can be found in the turmoil that rippled through the banking sector, starting with the collapse of Silicon Valley Bank in March. Although many firms tapped credit lines early in the pandemic due to uncertainty over the economic outlook, this did not cause similar failures. By contrast, the latest bout of bank turmoil was triggered by a combination of factors. The massive pandemic-era QE program led to a sharp rise in demandable claims, prompting banks like SVB to invest in Treasuries, which lost value as interest rates rose. Subsequent concerns over banks’ financial health caused a run on deposits. According to Rajan, some banks are making the same kind of mistakes they made in the past, and policymakers must be wary about creating moral hazard by rescuing failed institutions.

3) Look out for unintended consequences and monetary policy’s future: Central banks should be mindful that aggressive monetary policy actions often lay the groundwork for future financial sector problems. Supervisors of the financial system are not infallible, and accidents can happen due to unforeseen consequences of policy decisions. As central banks consider new methods of expanding monetary policy, they must also think of ways to exit those programs because the ramifications are not always clear. Accidents can happen when unintended consequences emerge, threatening financial stability. Today, some policymakers are asking whether they are raising rates too much, as higher rates could make a fragile system more fragile. With monetary policy colliding with financial stability concerns, it is possible that officials stop raising rates before achieving their inflation objective, aiming to stave off a shock to the system that exposes hidden cracks.