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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