Concerns about the Fed’s balance sheet
Bill Dudley explains that the biggest risk the Fed is facing due to the current size of his balance sheet is interest rate risk: if the Fed down the road has to increase short-term interest rates then the yield on the Fed’s portfolio will adjust very slowly because its duration is pretty long, then the interest earned on its assets will be lower than the interest the Fed will have to pay on excess reserves. The Fed will incur significant losses. The level of short term interest rates that will cause this result is around 3.5%. As for Fed independence, Bill Dudley argued, that at the moment is not at risk because there is no conflict between what the Fed, the Treasury and the Congress want. The issue of independence will become more meaningful when the Fed decides to increase interest rates in the future against the administration’s wishes especially since the fiscal position of the US has significantly deteriorated.
The Fed’s Longer Term Challenges: After the Pandemic
By: Bill Dudley – Princeton University
The concerns about the ECB’s balance sheet
Belz and al. explain that the difference between the Fed’s balance sheet and the ECB’s is that about 80 percent of the assets on the Fed’s balance sheet are securities issued by or guaranteed by the U.S. government. Swap lines with other central banks account for another 6 percent. Lending to the banks is most of the remainder. In contrast, at the ECB, securities of all kinds comprise about 60 percent of the total portfolio and lending to banks (almost all long-term operations) account for close to 20 percent, and the rest is a mix of other assets.
François Villeroy de Galhau, Governor of the Banque de France warns:
In the current context of an unprecedented rise in public debt, this independence is more important than ever. France’s debt should exceed 115% of GDP by the end of this year. There can be a strong temptation in this case to give in to fiscal dominance. This can take different forms, including two that are frequently cited, and seductive precisely because they are illusory: the cancellation of the public debt held by the central bank, or the similar idea of converting it into perpetual debt. The cancellation of this debt would be tantamount to the monetary financing of public deficits, the prohibition of which is one of the founding pillars of the agreement creating the euro. More importantly, we need to do away with this myth of “magic money”. There is no such thing as a free lunch. If the central bank cancelled the debt it holds, it would book an equivalent loss on its balance sheet and collective wealth would be reduced by the same amount. Moreover, the bank deposits linked to this monetary creation will have to be remunerated by the central bank when interest rates return to positive territory, and will therefore cost as much as a short term debt. And if, as some people are suggesting, the central bank committed to never raising interest rates, that would trigger a potentially uncontrollable inflationary spiral.
Monetary policy in the face of the Covid crisis
By: François Villeroy de Galhau – Banque de France
What’s the ECB doing in response to the COVID-19 crisis?
By: Sage Belz, Jeffrey Cheng, David Wessel, Daniel Gros, Angela Capolongo – Brookings
