IMF Research Bulletin summarizes some of the recent research activities of the IMF.


IMF Research Bulletin summarizes some of the recent research activities of the IMF.

Manmohan Singh and Haobing Wang

In this research summary, we highlight two policy implications from central bank balance sheet policies: (a) assets held due to quantitative easing are not the same as “reserves” (or deposits of the banking system at the central bank), and (b) conventional interest-rate policy and balance sheet adjustments consist of two independent dimensions of monetary policy and they differ in their respective financial spillovers to emerging markets.

Short-term policy rates in many advanced economies (AEs) have remained persistently low since the aftermath of the recent financial crisis. In an effort to manage sluggish economic recoveries and reinvigorate growth, several leading central banks (e.g., the Federal Reserve in the United States, the Bank of England, the European Central Bank, and the Bank of Japan) have carried out several rounds of quantitative easing (QE) to provide further monetary stimulus.

While the empirical evidence for the financial spillovers of QE is well documented, the economic explanation of its international transmission remains relatively obscure. The February meeting minutes of the Federal Open Market Committee (released March 2017) mentioned “that a change to the Committee’s reinvestment policy would likely be appropriate later this year”—i.e., the Fed’s balance sheet will unwind. Brainard (2017) suggests that cross-border spillovers will have important implications if policy rate hikes and balance sheet reductions are not equivalent.

Unwinding Central Bank Balance Sheets May Not Lead to Tightening

Federal Reserve policymakers have recently started discussing when to start gradually reducing their $4.5 trillion balance sheet. Minutes of their March meeting suggest “that a change to the Committee’s reinvestment policy would likely be appropriate later this year.” This is a subject that the Fed has approached cautiously, out of concern that any decision to shrink the balance sheet would be seen as a tightening of monetary policy. We argue that in fact, unwinding may not be tantamount to tightening.

Why? First, because letting the balance sheet shrink would release “good” collateral such as U.S. Treasury securities, while reducing the excess reserves that commercial banks keep on deposit at the Fed. These deposits came about when the Fed bought trillions of dollars in securities in a bid to keep long-term interest rates low, a strategy known as quantitative easing. Many of the securities were bought from non-bank financial firms, (i.e., pension funds, insurers, asset managers) which stashed the proceeds at depository institutions. Those banks in turn deposited money at the Fed, where it earned interest (only banks can earn interest on excess reserves.) Nonbanks are likely to reuse good collateral, rather than sizable deposits at banks that have remained idle.

There may not be a one-to-one relation between policy rate hikes and the unwinding of central bank balance sheets (Singh, 2017). New regulations instituted to make the financial system safer require banks to hold more “high quality liquid assets.” Both U.S. Treasuries and excess reserves count as high quality liquid assets. But that is where the similarity ends. Good collateral, when pledged, is constantly reused in a process that is similar to money creation which takes place when banks accept deposits and make loans. That is why good collateral and excess reserves are very different in their implications for market functioning. The relation between the two may not even be positive—i.e., presently, the U.S. Treasury in the hands of the market, with reuse, is likely to lubricate markets, while excess reserves (or money) has remained idle in recent years.

Increasing the availability of good collateral also creates incentives for the reuse of other, less desirable collateral. Most collateral in the markets is exchanged (for money) as a portfolio of securities, rather than as individual securities. Research suggests that at present, collateral reuse rate is below two, on average, down from about three times before the Lehman crisis. The reuse rate is unlikely to bounce back since collateral does not flow within a vacuum but needs bank balance sheets to move. However, private sector balance sheets remain clogged by deposits, a byproduct of QE. Assuming no changes in regulations (e.g., leverage ratio), a lower level of deposits will allow collateral reuse to increase, as balance sheet space at banks becomes more available.

Deposits have taken too much balance-sheet space of the banking sector—excess reserves of the banks at the Fed are presently over $2 trillion. This inhibits financial intermediation and in turn, monetary policy transmission. As an analogy, oil is only needed for lubricating a car’s engine; similarly, excess reserves, are needed only to smooth out the need for reserves in the financial system. Excess reserves were close to zero before the Lehman crisis. Now instead of an “oil change” we are carrying the oil in the car trunk, in our homes, everywhere.

Presently markets have a strong appetite for good collateral. As seen in the past year, policy rate hikes may not percolate to the long end of the yield curve and vice versa, because the investor base is very different for the short and long end. For example, from the time of the Fed’s 25 basis-point rate hike on December 16, 2105, until the eve of U.S. elections on November 8, 2016, the yield on the 10-year U.S. Treasury note declined, to 1.8 percent from 2.3 percent, as markets digested duration despite sizable sales of Treasuries by many emerging markets throughout 2016.

So, unwinding of a central bank’s balance sheet may not result in tightening. Collateral that will be released (from the asset side of the Fed balance sheet) to the market, with reuse, is a far better lubricant for the financial system than the reduction in banking system deposits, (i.e., reserves balances on the liability side of the Fed balance sheet). Although the Dodd Frank Act and Basel III make it more expensive for collateral to be reused, the increase in the balance sheet space of the banking system (due to central bank unwind) may more than neutralize the regulatory cost. Thus, a leaner central bank balance sheet may allow for a higher policy rate in this cycle, if unwind does not result in tightening. There are sound theoretical reasons why, in normal times, lean balance sheets allow central banks to focus on the core of its mandate (Bindseil, 2016).

Central Bank Balance Sheet Policy and Spillovers to Emerging Markets

A recent IMF paper (Singh and Wang, 2017) provides a theoretical framework to study the financial spillovers of QE, and QE unwind by the Fed. Although some economists (e.g., Bernanke, 2015) argue that AE central banks can maintain their large balance sheet(s) and there may be no need to unwind these, it may be prudent for EMs to be equipped with the necessary tools in case the economy they are anchored to decides to unwind its balance sheet as part of its monetary policy.

Going forward, several AE central banks will be able to exploit two major dimensions of monetary policy: the short-term policy rate and balance sheet adjustment. As demonstrated by our model, this allows for effective and independent control over both short-term and long-term interest rates. EMs that peg to AEs may need to assess their policy framework and complement their financial stability toolkit by including macroprudential and capital flow management measures. Furthermore, EMs will benefit from recognizing that balance sheet reductions and policy rate hikes may not be equivalent.

We also argue that understanding market signals such as repo rates is crucial, since these have traditionally guided the policy rate. A normal liftoff assumes that all short-term rates will move in line with the policy rate; otherwise, monetary policy transmission could be compromised. Although there has been no balance sheet unwind since Fed’s liftoff, the wedge between short-term rates is higher than in the past. When the Federal Reserve unwinds, this could lead to a larger wedge between short-term repo rates and policy rates, since collateral velocity (i.e., the reuse of collateral when released to the market) is not under the central banks’ control.


  • Bernanke, Ben S., 2015, “Monetary Policy in the Future,” Speech at the IMF’s Rethinking Macro Policy Conference III, April.

  • Bindseil, Ulrich, 2016, “Evaluating Monetary Policy Operational Frameworks” Jackson Hole Economic Policy Symposium, Kansas Fed, August.

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  • Brainard, Lael, 2017, “Cross-Border Spillovers of Balance Sheet Normalization,” Speech at NBER’s Monetary Economics Summer Institute, New York, NY, July 13, 2017.

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  • Federal Open Market Committee, 2017, Minutes of the February Meeting, March 15.

  • Singh, Manmohan, 2017, “Why Shrinking the Fed Balance Sheet May Have an Easing Effect,” Financial Times, Alphaville, April 24.

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  • Singh, Manmohan, and Haobing Wang, 2017, “Central Bank Balance Sheet Policies and Spillovers to Emerging Markets,” IMF Working Paper 17/172. International Monetary Fund, Washington, DC.

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