Central Bank Balance Sheet Expansion and Financial Stability: why less can be more

Contributor(s): Professor Raghuram Rajan | When the Federal Reserve expanded its balance sheet via large-scale asset purchases (quantitative easing) in recent years, we find an increase in commercial bank deposits with a shortening of their maturity, and also an increase in outstanding bank lines of credit to corporations. However, when it halted the balance-sheet expansion in 2014 and even reversed it during quantitative tightening starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the past expansion of the Fed’s balance sheet left the financial sector more sensitive to potential liquidity shocks when the Fed started shrinking it, necessitating Fed liquidity provision in September 2019 and again in March 2020. If the past repeats, the shrinkage of the central bank balance sheet is not likely to be an entirely benign process and will require careful monitoring of the size of on- and off-balance-sheet demandable claims on the banking sector. It is reasonable to ask whether the prior expansion and then shrinkage of the central banks balance sheets had left the private financial sector more vulnerable to such disruptions, and as a result, dependent on further liquidity interventions.