Central banks selling fewer bonds?

The size of central bank balance sheets matters for inflation and interest rates.

| 9 min read

Markets are fixated on changes in official interest rates. In recent years, monetary policy has also been driven by significant changes in the size of central bank balance sheets. Both the Fed and the European Central Bank have bought large quantities of bonds to depress long-term interest rates. They are now reducing these portfolios.

The US is aggressively selling mortgage-backed securities and Treasury bonds from its holdings to shrink its balance sheet. The ECB is reducing its bond portfolio as bonds fall due for repayment and has made a larger reduction in its balance sheet by securing repayment of loans from commercial banks.

The ECB and the Fed

The ECB reached a peak level of €8.56 trillion in assets by December 2021. This was up a massive 83% compared to the end of 2019. By the end of 2022, this had fallen to €7.951 trillion. In 2023, it fell again to €6.935 trillion. It reduced its holdings of bonds by €243 trillion in 2023, and its loans to banks by €914 trillion.

The pace of decline in its bond holdings has been kept under control as the ECB does not wish to see disruption in the market in the wider range of different national bonds that make up its portfolio. It is conscious of the need to avoid pushing up borrowing rates for countries like Italy and Greece unduly, given their high levels of debt.

The ECB is likely to continue its policy of cutting its balance sheet as bonds reach repayment, but not accelerating the process by selling into the market. The ECB has done most of its slimming by reducing loans to commercial banks. The banks are generally well-financed and can make loans without additional support from the central bank.

The Federal Reserve (Fed) reached a peak balance sheet of $9 trillion. This was up from $4.17 trillion at the end of 2019, a significant rise of 117%. By April this year, that was down to $7.426 trillion. The Fed is selling $60bn of bonds and $35bn of mortgage-backed securities each month. The Fed is keen to exit mortgage-backed securities altogether, having become a dominant presence in the market through its large acquisitions. At the current rate of runoff, it would take almost six years to complete the exit if it could get up to the full $35bn a month.

The Fed reports the maturity profile of its Treasury holdings. Half of the portfolio matures in under five years, allowing substantial balance sheet contraction without a large programme of sales in the market. The Fed is currently reviewing whether it should cut back its sales of Treasuries.

Given the way mortgage rates have been driven up, and given the way inflation has been coming down, there is a case for slowing the rate of the Fed balance sheet decline. Selling more bonds into the market at a time of substantial new issues by the Treasury must lead to lower prices and higher interest rates. As the Fed is now asking when it should start to cut interest rates, with the market expecting maybe two cuts over the rest of this year, there is a stronger argument for beginning to decelerate the bond sales first.

The Fed considers scaling back

The minutes of the end-of-March meeting reveal that the Fed is close to reducing its sales of Treasury bonds. It said: “In their discussion regarding how to adjust the pace of runoff, participants generally favoured reducing the monthly pace of runoff by roughly half.” As it is still keen to runoff most of the mortgage securities position and end up with a portfolio of Treasury bonds, it is considering significant reductions in Treasury sales. It wants the banks to have more than “ample reserves” to avoid a further credit crunch. As a result, “the vast majority of participants thus judged it would be prudent to begin slowing the pace of runoff fairly soon.” It wishes to avoid the problems runoff caused in 2017-19. They also implied they are keener to runoff the shorter-dated than the longer-dated Treasuries. Part of the unexplained thinking might be that this would limit the amount of loss they will be taking, as the losses from selling longer-dated paper in the market will be considerably larger than the shorter.

The Bank of Japan did not expand its balance sheet as much over the pandemic as the Fed and ECB. It has been relatively stable in the last three years, rising from 714,000 billion yen to 756,000 billion yen ($5 trillion). Japan has been buying and holding yen bonds for many years. In 2020, Japan bought more than usual but not on the scale of the Fed. The People’s Bank of China also kept a steady rate of increase in its balance sheet over COVID, avoiding the large purchases of bonds.

The Fed needed to do something extraordinary in March 2020 when lockdowns threatened the global economy. Asset values were falling sharply, and liquidity dried up in markets. The Fed’s special Quantitative Easing, followed by the ECB and other advanced country banks, saved the day. Continuing the special injections of cash and taking rates even lower in 2021 when easing of lockdowns and recovery were on the agenda probably led to faster inflation. The Japanese, who expanded the central bank balance sheet less strongly, and the Chinese, who did not try special purchases of bonds, kept their inflation rates much lower.

Both the Fed and the ECB decided on a sharp reduction in their balance sheets as well as a large increase in interest rates to bring inflation back down. The Fed has said it is now examining cutting back on its sales of Treasuries. It had to temporarily reverse some of its big balance sheet reduction when regional banks were at risk. The ECB is more circumspect about selling bonds as it does not want longer-term interest rates to diverge between the stronger and weaker national economies in its membership.

Implications of less quantitative tightening

If central banks sell bonds and reduce the pace of that runoff, it is a helpful influence on the bond and mortgage markets. Central banks may well conclude that the housing markets have been bruised enough by dearer and scarcer mortgages and may take that into account when considering what to do about their balance sheets. There is no necessity to cut them back, and now there is no normal size of balance sheet they can turn to. Buying and holding bonds has become a part of monetary policy since the financial crash of 2008-9. All things being equal, selling fewer or ending sales should lift the bond markets a bit.

Some say the central banks will need new capital from their governments to make good their losses.

There are difficult issues over reporting the losses. These Central Banks paid very high prices for many of these bonds. The plan was to boost prices and therefore slash interest rates. When the Banks want interest rates higher, bonds tumble and deliver losses. Holding the longer-dated bonds until they mature should reduce the eventual loss taken as many of the long bonds have current market prices well below repayment value.

Many of them were bought by the central banks at prices above repayment value, so there will still be some losses at redemption. There is also the accounting for holding the bonds. The Fed makes a running loss as it pays the higher short rate to commercial banks for their reserves held with it, whilst getting a lower interest return on the bonds it paid so much for. The ECB decided not to pay any interest on minimum reserves held by commercial banks to cut its losses.

Some say the central banks will need new capital from their governments to make good their losses. The Fed says it will simply report the losses but cannot run out of money as it is a Central Bank that can always generate it. The ECB says much of the responsibility for reporting the losses and, if necessary, providing new capital rests with the national member states’ Central Banks within the system. They are currently covering the losses with retained profits from previous years.

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Central banks selling fewer bonds?

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