With rate cuts coming, attention will turn to central bank balance sheets, said Morgan Stanley.
The bank laid out in a note where the balance sheets are now and where they are going.
Market attention on central bank balance sheets will likely increase this year, including the composition of balance sheets and the form of quantitative tightening (QT), stated Morgan Stanley. For example, the United States Federal Reserve, the Euroepan Central Bank (ECB) and the Bank of Japan (BoJ) will have very different paths forward.
While balance sheets may or may not revert to pre-COVID levels, the bank thought they will certainly not revert to pre-GFC (global financial crisis) norms.
Morgan Stanley draws four lessons from the cross-country comparison:
— QT isn’t the opposite of quantitive easing (QE). QE took place amid market disruptions and widespread slumps in growth; QT is happening with healed markets, amid growth and inflation. With QE, central banks bought securities in the secondary market; some central banks are making sales, but most have passive QT where the Treasury issues the debt, often at different maturities. QE helped central banks to signal that low policy rates would stay; QT cannot have the reverse role away from the lower bound.
— Central bank balance sheets differ substantially across economies. The US relies more on capital markets, so QE took the shape of asset purchases. The eurozone economy relies heavily on bank lending, and so the ECB created TLTROs (Targeted Long-Term Refinancing Operations) for banks in addition to QE. The market has to absorb securities shed through QT, but early prepayments of TLTROs have no such analog.
— Central banks can clearly make losses. Morgan Stanley highlighted how negative income and negative equity at some central banks don’t have macroeconomic ramifications. The clearest example is the Czech central bank (CNB), which operates regularly with negative equity. However, political considerations of central bank independence might come to dominate accounting.
— Balance sheets should shrink substantially but not revert to the past. The Fed has committed to an “ample reserves” regime that the bank expected will have over $3 trillion in reserves. Likewise, the ECB decided to continue operating the floor system for steering short-term money market rates in its recent operational framework review, although with an emphasis on incentives to reduce banks’ reserve holdings as much as possible.