The Bank of England’s (BoE) executive markets director has said the balance sheets of central banks will start to shrink as the Covid-19 recovery takes hold – and has also suggested the possible adoption of digital currencies in the future.
Andrew Hauser made the comments in a speech at the International Finance and Banking Society 2021 Oxford Conference on Monday, that was focused on the financial system(s) of tomorrow.
“There’s been particular focus on the sharp increase in the size of central bank balance sheets, most recently as the result of the extraordinary steps required to respond to the economic impact of Covid-19. In due course, those balance sheets will start to shrink again as the recovery takes hold.
“But as that tide recedes, what’s left will not be what we knew 10 to 20 years ago. And that’s because fundamental shifts in economic and financial structures mean that central bank balance sheets are also set to play a much broader role in the future,” Hauser said.
Adopting digital currencies
Hauser also talked about the growing popularity of cryptocurrency circles, stating that central banks may potentially provide new retail payment media, in the form of Central Bank Digital Currencies (CBDCs).
His comments come as a number of countries have taken steps to make it legal for residents to pay for goods using crypto, like Bitcoin. Panama, El Savador and Ukraine are among the places that have adopted it as its popularity has grown.
Central bank of today
Hauser said the BoE has assets of nearly £1trn – equivalent to almost half the annual output of the UK economy.
The ratio is 10 times what it was in 2006, and more than double any previous peak in its 327 year history, including the wars of the 18th and 20th centuries.
Hauser explained in his speech that quantitative easing (QE) has been a key driver in boosting the UK’s balance sheet.
“While balance sheet size may have grabbed the headlines, arguably the more important trend in recent years has been the broadening scope or breadth of uses to which central bank balance sheets have been put,” he said.
He also talked about how the shift was particularly on display during the early stages of the Covid-19 crisis, with central banks reaching for an unparalleled variety of policy tools, ranging from standard interest rate and liquidity operations or asset purchases, to term lending, foreign currency and targeted credit support operations.
“Many of those Covid-specific interventions have already begun to unwind. The UK’s Covid Corporate Financing Facility, for example, closed to new lending in March 2021, and will liquidate completely early next year,” he told the conference.
Hauser also stated that QE will start to run off too, when policy makers judge it to be warranted by the outlook for inflation and activity.
Financial market participants have a much higher structural demand for high-quality liquid assets to meet potential outflows – and said the second driver of structurally higher central bank balance sheets relates to trends in global interest rates.
Hauser said the third driver shaping the outlook for central bank balance sheets was the potential development of CBDCs, developing on his earlier comments.
“Research work in this area has exploded recently, as the debate about the need for an unquestionably safe state-backed retail digital payments medium for online transactions has intensified. No decision has yet been made as to whether to introduce a sterling CBDC, or what form it might take - and the technological development work required would take some years to complete.
“But the implications for the size of the Bank’s balance sheet could be significant: an illustrative scenario in the Bank’s June Discussion Paper, for example, considered a world in which a fifth of household and corporate deposits, worth upwards of £400bn, transferred to a new digital currency,” he added.
Hauser also set out the close relationship between central banks and the financial markets.
“We rely on them, directly, to transmit policy to the wider economy; and, indirectly, to channel savings into investment, price and manage risk, provide – and innovate new – services to households and firms.
“But that reliance means we also need to be ready to intervene to ensure markets function safely and effectively,” he said.
Principles for tomorrow’s central bank
The BoE markets director concluded with his thoughts on what the central bank balance sheets of the future might look like.
He said they will be structurally larger, even after current QE programmes unwind; and might even have incorporated CBDCs.
He also stated they will also be more variable as “lower global interest rates and a broader liquidity insurance toolkit mean balance sheets play a more active countercyclical role”.
“Central banks cannot shirk their responsibilities to maintain monetary and financial stability. But they do have choices about how to do so – and I’ve suggested three principles to help ensure they do so in ways that help markets function well and safely, in the service of the wider economy.
“By gathering regular and detailed intelligence on market structures. By placing the burden of proof on explaining why financial markets cannot do it better. And, where intervention is needed, by setting clear ex ante expectations, minimising predictable adverse effects, and developing clear exit strategies,” Hauser concluded.