In a speech at the European Central Bank’s (ECB) conference on money markets, Philip Lane, member of the Executive Board of the ECB, drew conclusions on the macroeconomics of central bank reserves.
First, even if much lower than the current level, the appropriate level of central bank reserves in the “new normal” steady state should avoid the risks associated with excessively-scarce or excessively-abundant reserves. Such a middle path would strike an appropriate balance between the benefits and costs associated with the creation of central bank reserves and also seems best suited to safeguard the stability of the banking and financial systems.
All else equal, the appropriate steady-state level of central bank reserves should be increasing in: the size of the banking system; the size of the overall financial system; and the overall size of the economy; the likelihood and potential severity of macro-financial tail events; the scarcity of safe assets; the effectiveness of micro-prudential and macro-prudential regulations (in combination with supervisory oversight) in curbing the incentives of banks to engage in excessive balance sheet expansion and maturity transformation; the mobility of deposits; and the policy prioritization attached to minimizing the risk of hitting the effective lower bound rate (ELB).
While this list is non-exhaustive, in working through it, each of these dimensions clearly also depends on the balance of the asset-side interventions (between refinancing operations and bond purchases) that are the counterparts to the issuance of central bank reserves. Amongst the list non-covered topics, structural changes in the financial system may also alter the future role of central bank reserves. In particular, these include private-sector digital finance innovations and the possible launch a central bank digital currency. Lane also did not cover global dimensions of central bank liquidity, including the macroeconomics of central bank foreign-currency swap and repo programs.
Lane also noted that a durable level of central bank reserves is likely required to ensure the sufficient provision of bank credit to enable the euro area economy to attain its steady-state potential output growth rate, in view of the importance of central bank reserves in underpinning the willingness of banks to extend credit in spite of the risks associated with illiquid assets (such as bank loans) in a world much more prone to macro-financial shocks. This steady-state level of central bank reserves likely has a positive trend component, in view of the connection between the optimal level of central bank reserves and the overall size of the financial system.
Second, in view of the trade-offs posed by each individual instrument, it seems proportionate from a macroeconomic perspective for a central bank to use a range of instruments to provide central bank reserves. Central bank reserves can be provided both through a structural bond portfolio on the one side, and a structural longer-term refinancing operation as well as a standard short-term refinancing operation on the other side. A mix of a structural bond portfolio and longer-term refinancing operations would provide longer-time liquidity to the banking system, while the short-term refinancing operations are well suited to the absorption of higher-frequency liquidity shocks. In turn, the relative contributions of each of these instruments can and should vary in response to various macro-financial shocks.
Third, the supply of central bank reserves should be elastic in the event of macro-financial stress. If it is understood that the supply will be sufficiently elastic under stressed conditions, this should reduce the precautionary demand for reserves in the steady state, since there is no need to excessively self-insure if reserves are reliably available under stressed conditions.
Fourth, it should be recognized that sustained surges in central bank reserves may also occur in the future if the configuration of shocks means that policy rates return to the neighborhood of the effective lower bound rate (ELB) and there is a renewed need for quantitative easing and/or credit-easing longer-term refinancing operations to preserve price stability.