What’s happening: The Bank of England (BoE) provided new details on its plan to shrink its balance sheet. While press reports have been focused on the BoE’s plans to sell assets, the critical difference between the BoE plan and the Fed’s plan is how the central banks will determine their minimum size. The BoE intends to shed assets until it is as small as possible in the short term, and get smaller over time. In contrast, the Fed plans to maintain a huge balance sheet and may continue to grow bigger.
What’s different: The key distinction between the two plans is how each central bank plans to determine its minimum size.
- The Fed does not know the minimum level of reserve balances necessary to maintain its “ample reserves” policy. The Fed wants to stop a bit before it achieves the minimum level, leaving a buffer to absorb volatility in reserve balances – it’s walking toward a wall blindfolded and trying to stop as close as possible without bumping into it.
- The Bank of England plans to shrink its portfolio to a level where there is some scarcity in the market for reserve balances and where banks regularly borrow from the BoE in open market operations. The BoE plans to lend to banks at the same interest rate it pays on reserve balances.
Implications of these approaches: The Fed’s plan incentivizes banks to demand high levels of reserve balances, so the Fed will stay big and get bigger. The BoE’s approach would push market rates a bit higher on average than the rate it pays on reserve balances – encouraging banks to economize on their reserve balance holdings, and allowing the BoE to shrink further.
The BoE approach, exported to America: The Fed could adopt a normalization plan similar to the BoE’s, with some key modifications.
- Maintain a small spread between the interest rate it charges on its loans and the interest rate it pays on reserve balances. This invigorates the interbank market, an important part of how banks manage their liquidity.
- Take much more aggressive steps to encourage banks to be willing to borrow from its standing lending facilities.
Another key change: The Fed could also consider offering banks Committed Liquidity Facilities (CLFs) – central bank facilities to provide commercial banks guaranteed, collateralized lines of credit for a fee, with the interest rate on draws on the line set above market rates. This would enable banks to comply with liquidity requirements in a way that frees them up to make more loans to businesses and families.