Does Size Really Matter?

by Michael J. Howell27. February 2013 10:46
According to latest market-talk the BoJ is the 'loosest' Central Bank worldwide simply because its balance sheet now stands at nearly 35% of GDP. Second is the ECB at 28%, while the BoE and the US Fed trail at 25% and 20%, respectively. Of course, this is absolute rubbish! Consider a counterfactual. A poor, cash-based economy, with no developed financial sector may well have a Central Bank balance sheet that is near 100% of GDP. Does this make it very loose? What matters here is the change in the size of the balance sheet. The last decade has (or should have) demonstrated that changes in the size of Central Bank balance sheets move risk premia on risk assets in the opposite direction. Thus QE policies reduce market risk and promote recovery. The size of Central Bank balance sheets relative to GDP is greater (1) the more that cash is used for trade; (2) the greater required reserves, and (3) the smaller the shadow banking sector. Hence, our point that this ratio cannot judge the stance of monetary policy. Rather it is a measure of financial development, if anything. Changes in absolute balance sheets matter way more. And, here is the main point. If the Fed had just shrunk its balance sheet by 15% would Wall Street still be at current levels, or would it be 20% maybe even 30% lower? Risk premia matter. Tell that to the ECB who have just let their balance sheet fall by 15%, and somehow (we scratch our heads) claim this is an easing. Watch out Eurozone!

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ECB Headaches

by Michael J. Howell13. February 2013 12:19

We do not accept the argument that the ECBs operating procedures are so different from the Fed and the BoE that a drop in the size of their balance sheet can be read bullishly simply because it supposedly reflects less take-up of distressed borrowing by banks. Moreover, we cannot see how arguing that the EONIA lending rate lies ‘close’ to the deposit rate floor indicates abundant liquidity. First, ECB balance sheet contraction proved the critical signal for the last crisis and low EONIA rates did not help. Second, the Eurozone money markets are not functioning. Problem banks are still unable to get funding and are forced to borrow at higher rates. Third, in the post-Lehman Crisis World where Central Banks increasingly operate interest rate corridors between lending and deposit rates they are able to control both the level of interest rates and the volume of liquidity. In the US and UK, Central Bankers now realise that greater volumes of liquidity decrease market interest rates. Thus, by flooding the system with liquidity, the Fed has successfully pushed investors back into risk assets. In short, the volume of liquidity maters, and matters a lot. Falling ECB liquidity from E1.67 trillion to E1.5 trillion is thus a bearish and NOT a bullish sign.

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