Goldman Sachs: Watch For ECB Balance Sheet Normalization

Get ready for interest rate normalization to shape central bank balance sheets to more traditional levels, achieving mean reversion after a significant trend of magnitude towards accommodation that has been historic in nature.

Goldman Sachs Group Inc (NYSE:GS) analysis didn’t use the exact words, but they did note with this new “neutral” central bank balance sheets will be larger than before the 2008 financial crisis, will hold more duration and, as a result the yield curve could flatten as a “neutral” stance is achieved. The report interestingly pointed to an additional tool in the Fed tool kit should it be needed.

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Goldman Sachs: Get ready for normalization of monetary policy

“At the global level, monetary policy is set to normalise. This entails raising policy rates towards more ‘neutral’ levels,” the report, written by Huw Pill’s economics research team.  Short-term interest rates are only one aspect of the monetary policy stance, they note, a departure from the financial crisis when central banks adopted a variety of non-standard policy measures, involving changes to the size and composition of their balance sheets.

Monetary policy normalization therefore will also entail re-shaping central bank balance sheets towards more neutral settings. The research report, titled “Defining the ECB’s ‘neutral’ balance sheet,” is quick to point out the benefits of significant leverage but not as quick on the risk disclaimer that might come with a larger balance sheet of sovereign debt, particularly in the emerging market. The report authors expect the “neutral” size of the balance sheet of a central bank such as the ECB to be higher after the crisis, and this, they opine, has several benefits:

(1) the central bank can deliver targeted ‘credit easing’ measures aimed at specific impaired market segments without stimulating the broader economy through quantitative easing, allowing a more targeted policy response; and (2) policy responses would be more timely, as institutional concerns about balance sheet expansion will not slow down policy response via changes to balance sheet composition.

Goldman Sachs considers “risk-free local currency assets

In an Emerging Market context, the authors note it is well-established that there are insurance benefits associated with holding large FX reserves if the economy has external FX denominated debt liabilities. “While this is not a major issue in most developed economies, the global financial crisis (GFC) has demonstrated that there can also be benefits associated with holding large risk-free local currency assets for a central bank like the ECB, given the risk that crucial private markets may seize up in a crisis.”

Separate analysis indicates the words “risk-free” used in conjunction with “local currency assets” that can and do include debt instruments are technically subject to default even in short duration.  The issue is where in a debt cycle a country and its “risk-free” assets are, and many have not yet achieved the point where short term debt falls into this category.

There are other impacts, the report noted. “If QE predominantly works through ‘portfolio balance’ effects (i.e. via a lower supply of government bonds), it may lead to a lower ‘neutral’ term premium. Consequently, this implies that a larger ‘neutral’ balance sheet may lead to a higher ‘neutral’ policy rate (i.e. non-separability of the ‘neutral’ rate and balance sheet). On the other hand, if QE predominantly operates through temporary signaling effects, the market implications are likely to be less significant.”

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Such analysis might have been more compactly communicated by saying the yield curve could flatten as a result of certain more “natural” re-balancing.  During crisis the “financial market frictions intensify” during neutral balance sheet environments, the report noted, as the report pointed to an additional tool in the Fed’s tool kit should the economy require additional support.

“By contrast, in times of crisis, financial market frictions intensify. In that environment, the design (both size and composition) of the central bank balance sheet matters. As reflected by previous experiences discussed above, it may be necessary to implement balance sheet measures that permit greater central bank intermediation and/or further stimulus to the economy once conventional instruments are exhausted (e.g. short-term policy rates reach their lower bound).”