Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets
When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks financed reserve holdings with deposits and reduced their average maturity. They also issued lines of credit to corporations. However, when the Fed halted its balance-sheet expansion in 2014 and even reversed it during quantitative tightening (QT) starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the financial sector was left more sensitive to potential liquidity shocks, with weaker-capitalized banks most exposed. This necessitated Fed liquidity provision in September 2019 and again in March 2020. Liquidity-risk-exposed banks suffered the most drawdowns and the largest stock price declines at the onset of the Covid crisis in March 2020. The evidence suggests that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability.
Rajan thanks the Fama-Miller Center at the Booth School and the Hoover Institution for research support. Steffen is grateful for financial support from the BMWi and DLR. We are grateful to Gara Afonso, Ryan Banerjee, Richard Berner, Wenxin Du, Michael Fleming, Florian Heider, Anil Kashyap, Gabriele La Spada, Lorie Logan, Stephan Luck, Emanuel Moench, Bill Nelson, Charlie Plosser, Rodney Ramacharan, Andrei Shleifer, Jeremy Stein, Bruce Tuckman, Quentin Vandeweyer, attendees at the Federal Reserve Bank of Kansas Jackson Hole Economic Symposium in August 2022 on “Reassessing Constraints on the Economy and Policy”, and seminar participants at Banque de France, Harvard Business School, Hoover Institution, NYU Stern Volatility and Risk Institute’s QFE Workshop, Petersen Institute for International Economics, and Wake Forest University, for helpful comments. An early draft of this paper was named “Liquidity Dependence: Why Shrinking Central Bank Balance Sheets is an Uphill Task”. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
- In the wake of the global financial crisis of 2007–09, the Federal Reserve embarked on an ambitious program of quantitative easing (QE...