The main challenge facing monetary policy makers is the sudden and rapid rise in inflation. Starting in 2021, inflation has risen substantially in many advanced economies. For example, in the US, consumer price index inflation jumped from 1.4% in January 2021 over the previous year to a peak of 9.1% in June 2022. Inflation rates from 12 months in the UK and the euro area rose similarly, from 0.9% at the beginning of 2021 to 9.6% and 10.6%, respectively, by October 2022. Even Japan, which for decades has experienced inflation close to zero or even negative, experienced an increase in rates of up to 4.3% in January 2023.

Policy Rate Hikes: The Expected Response to Inflation

Given that central banks are tasked with maintaining price stability, we would expect to see policy rate increases in response to rising inflation, and in some cases, we have. However, the implementation of quantitative easing (QE) policy since the Great Recession of 2007-09 may have complicated the decision to increase the policy rate in certain economies. Looking at the relative sizes of the balance sheets held by the central banks of these economies can help us understand why.

QE and its impact on central bank balance sheets

QE policy generally involves buying long-term government bonds in order to lower long-term interest rates and thus stimulate the economy. The impact of QE on central bank balance sheets can be demonstrated through a simple example. Let the first table below be the central bank balance sheet before QE. It consists of short-term government bonds and long-term government bonds on the asset side and reserves and cash on the liability side.

Central bank balance sheet before QE
Assets Passive
Short-term government bonds $20 Bookings $25
Long-term government bonds $10 Money $5

Now suppose the central bank executes a QE policy that involves buying another $50 in long-term government bonds; By paying off these bonds, it increases the reserves that commercial banks hold at the central bank. The balance sheet after QE is shown in the table below.

Central Bank balance sheet after QE
Assets Passive
Short-term government bonds $20 Bookings $75
Long-term government bonds $60 Money $5

As we can see, the central bank’s balance sheet expands due to QE. More specifically, QE purchases have two effects:

  • The bonds that the central bank has as assets increase.
  • They increase by an equal amount the central bank’s liabilities, a narrow measure of the money supply called the monetary base, which consists of currency held by the public and bank reserves.

If the long-term interest rates earned by government bonds on the asset side of the balance sheet are higher than the short-term interest rates paid by reserves on the liability side, then the central bank could generate profit. . In many countries, the profits generated by the central bank are passed on to the national government. This has generally been the case since the Great Recession.

Central Bank Bond Portfolios and Interest Rate Risk

However, such a portfolio leaves the central bank exposed to interest rate risks. An increase in interest rates means that the central bank starts paying more for its liabilities, while the amount it earns from coupons on its long-term bond portfolio remains unchanged. Therefore, if interest rates start to rise, the central bank faces reduced revenue or even losses. Because central banks normally return their profits to the government, decreased revenue or losses can increase the fiscal deficit.

This incurred loss could be substantial if the central bank holds a lot of long-term bonds. For example, suppose the interest rate rises enough that the average interest rate paid on central bank liabilities is 1 percentage point higher than that paid on central bank assets. In this case, the annual loss would be roughly equal to 1% of the size of the central bank’s balance sheet. Therefore, the larger the balance sheet, the greater the potential loss.

The balance sheets of four central banks grew

The following figure compares the balance sheet sizes of the four major central banks (the Federal Reserve in the US, the Bank of England in the UK, the European Central Bank in the euro area, and the Bank of Japan in Japan). ) relative to gross domestic product. (GDP) between the first quarter of 2007 (the blue bar), just before the Great Recession and before QE, and the first quarter of 2021 (the orange bar), when inflation began to rise rapidly.

Balance sheet size and policy rates at four central banks

SOURCES: Board of Governors of the Federal Reserve System, Bank of England, European Central Bank and Bank of Japan.

The balance sheets of the four central banks show considerable growth relative to the GDP of their partner economies due to the QE policies implemented after the Great Recession. In the US, the Federal Reserve’s balance sheet (relative to GDP) increased from 6.4% to 34.8% between the first quarter of 2007 and the first quarter of 2021. Meanwhile, the Bank’s balance sheets of England and of the European Central Bank increased by 5.3%. % to 44.3% and from 12.6% to 60.3%, respectively, during this same period. The Bank of Japan’s balance sheet jumped from 22.2% in early 2007 to 136.7% in early 2021. With balance sheets this large, raising the policy rate could impose a high cost on central banks themselves; In turn, this could affect the revenues of their respective governments in their countries.

To illustrate just how high this cost could be, let’s take a look at the euro area: for every 1 percentage point increase in the difference in the average interest rate between its liabilities and assets, the European Central Bank’s income is reduced by about 80 billion euros.

The pace of official interest rate responses at central banks

Monetary policy responses to rising inflation differ in magnitude among the central banks in our analysis. In the first half of 2022, the Federal Reserve began a cycle of rate hikes, and within a year raised the policy rate target range from 0% to 0.25% to 4.75% to 5 % in March 2023. Similarly, the Bank of England raised its policy rate from 0.1% to 4.25% in 14 months.

On the other hand, the response of the European Central Bank has been slower and somewhat smaller in magnitude, despite the fact that its inflation rate has exceeded that of the US. The policy rate for the euro area had only risen to 3.5% in March 2023. Finally, the Bank of Japan has continued to maintain its loose monetary policy stance, keeping its policy rate unchanged at -0.1% despite the fact that the country’s inflation rate is well below above the central bank’s 2% target. The green dots in the figure above represent the policy rate of each central bank as of March 2023.

If we look at the graph, we can see that central banks with a higher balance sheet to GDP ratio in early 2021 had policy rates in March 2023 that were lower than the policy rates of central banks with a lower balance-to-GDP ratio. balance sheet and GDP; in other words, central banks with larger balance sheets appear to have had more passive policy responses. This could be a coincidence or could reflect the central bank’s concerns regarding the recession or bond portfolio losses.

It is important to note that economic conditions vary around the world and therefore many factors can cause central banks to choose different monetary policy responses. For example, the slower pace of rate hikes by the European Central Bank may be due to concerns about economic risks and the shock caused by the Russian invasion of Ukraine in 2022. Policymakers may also assess a rising inflation rate different. The incoming governor of the Bank of Japan, for example, has said that “it will take some time for inflation to sustainably and stably reach the [Bank of Japan’s] 2% target,” and as such, the central bank’s loose monetary policy stance remains an appropriate approach.

Many factors shape monetary policy decisions

Is the negative relationship between policy responses and the size of central bank balance sheets that we observe in our analysis simply coincidental? We certainly hope so. The main role of central banks is to maintain price stability within an economy, not to generate revenue for the government. Therefore, income should not be a determining factor in monetary policy decisions.

However, the reality is that central banks face political pressure or public criticism when it comes to making and losing money. The government will feel a reduction in revenue or a loss and therefore one way or another will eventually be borne by the public, the consequences of which may be difficult for political authorities to absorb.


  1. The euro area, or eurozone, is made up of the 20 member states of the European Union whose currency is the euro.
  2. See the article of February 23, 2023 “Incoming BOJ chief says low rates still appropriate, for nowin US News & World Report.
  3. This concern is not idle. Augustin Carstens, director of the Bank for International Settlements (often called the bank of central banks), warned against risk of allowing mounting losses to deter central banks from fighting inflation.

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