In 2008–09, the US Federal Reserve started buying government bonds and mortgage-backed securities from the financial market, paying sellers with central-bank money—that is, reserves. Reserves, like cash, are among the most liquid and safest assets on the planet, and one might think that such operations, repeated a number of times since, should make the financial markets safer. But what if they do not?
Instead of helping the market with easy liquidity, the Fed’s quantitative easing, as the approach is called, is hurting it by creating an addiction, argue New York University’s Viral V. Acharya, Chicago Booth’s Raghuram G. Rajan, Booth research professional Rahul Singh Chauhan, and Frankfurt School of Finance & Management’s Sascha Steffen. Withdrawing the liquidity will cause withdrawal pangs and instability, they contend—and the longer the central bank expands its balance sheet with reserves, the longer it will take to bring down the reserves and normalize conditions safely.
The researchers analyzed bank-level data starting in 2008, when the Fed spent trillions buying long-term government bonds and other financial instruments from the private sector. The low interest rates that resulted from this quantitative easing were meant to entice businesses to take out loans so they would grow and create jobs—the idea being that when the economy had rebounded and consumers were again spending, the Fed could easily and safely shrink its reserves by selling the US Treasurys it had bought, or letting them mature and roll off its balance sheet.
But sustained quantitative easing (and subsequent tightening) may be less benign, and more difficult to reverse, than previously thought. When reserves expanded from less than 5 percent of GDP in 2008 to more than 15 percent in 2014, commercial banks began generating substantial potential claims on available liquidity, the researchers find. Fed-created reserves are assets, and commercial banks often finance them with short-term liabilities such as deposits. Banks’ deposits grew from about 50 percent of GDP to 60 percent over the same period, according to the analysis. Within deposits, banks shifted from longer-term time deposits to short-term demand deposits, increasing the need for reserves if depositors demanded their money back. Because reserves are safe but low-yielding investments, banks sought additional revenue streams by simultaneously offering higher credit-card limits to households and larger credit lines to corporations and investors. Their outstanding credit lines increased from 12 percent of GDP to more than 15 percent by September 2014.
The Fed then halted its balance-sheet expansion and began shrinking reserves in 2017, cutting them by more than half. However, the claims that banks had issued on liquidity, such as demand deposits and credit lines, remained flat. The study suggests that, with fewer reserves to lean on, banks were in a much tighter liquidity position, which may have made them less willing to help when financial markets subsequently turned out to be short on liquidity.
Since then, the Fed has twice stepped in to backstop illiquid markets—once in September 2019 and again in March 2020 at the onset of the COVID-19 pandemic. During the pandemic, when the Fed increased reserves from about 7 percent of GDP to more than 17 percent, bank deposits jumped again from 60 percent to almost 80 percent of GDP and credit lines rose to about 17 percent of GDP.
The researchers worry today’s lingering inflation and the Fed’s interest-rate hikes might set off more instability if cash-strapped banks hoard liquidity that other institutions need. If that happens and the Fed has to rush in to stabilize government bond markets, the Fed risks muddling its inflation-fighting communication—raising rates on one hand, and pumping in liquidity on the other. It may also look as if the Fed is financing the government, something no central bank wants to be seen as doing when it is fighting inflation. “While central banks have always had a duty to provide emergency liquidity, doing so on a sustained, large-scale basis is an entirely different kettle of fish,” the researchers write.
They urge US regulators to gain a greater understanding of commercial-bank behavior before tackling potential solutions, which could include stricter rules for the liquidity or deposits banks must have on hand. And while the researchers say their findings are specific to the Fed, quantitative easing and tightening are embraced by central banks around the world. “The empirical finding is indeed that a larger central bank balance sheet is correlated with more demandable claims, not less. Central banks have to be alert for growing liquidity mismatches during the process of quantitative tightening, and respond to them,” they write.
Viral V. Acharya, Raghuram G. Rajan, Rahul Singh Chauhan, and Sascha Steffen. “Liquidity Dependence: Why Shrinking Central Bank Balance Sheets Is an Uphill Task,” Working paper, October 2022.
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