The Covid crisis has required strong and prompt action by central banks consistent with their mandates. In March, disorderly conditions reached the core financial markets, posing a very real threat to the stability of the financial system — by far the most serious threat since the global financial crisis. Underlying this disorder in markets was an economic downturn almost unprecedented in both its scale and pace.
The response has included a major program of asset purchases and lending by central banks, with a corresponding growth of balance sheets. This has been the right thing to do to reduce borrowing costs, boost cash flows and more broadly support economies, and it has shown how essential it is to have truly independent central bankers. But the financial system mustn't become reliant on these extraordinary levels of reserves.
Central banks have been able to meet their objectives of monetary and financial stability, and support the well-being of citizens, through the crisis so far by performing two vital functions in recent months.
First, they've helped counteract the economic and market turmoil. Among other consequences, the Covid crisis could have led to the emergence of risk premiums in financial markets, which would have elevated the cost of borrowing well beyond levels consistent with the monetary and financial stability goals of central banks.
The fact that the predominant borrowers in this emergency are governments — reflecting the essential role of the state in such a crisis — makes no difference to the underlying economics or the importance of keeping borrowing costs in line with objectives. And it's worth remembering that the reform of the financial system since the last crisis has meant that banks are in a position to support households and companies through this emergency, acting to absorb the shock rather than amplify it.
Second, central banks have acted as a buffer to underpin the functioning of financial markets, by enabling the creation of reserves to meet surges in demand for high-quality liquid assets in stressed conditions. Absent this, we may well have seen a spiraling in disorderly market conditions.
As our economies start to reopen, there are three crucial issues for central banks that have become apparent during the pandemic.
The first is institutional. Effective economic policy requires well-defined and strong institutions, which are transparent and accountable. Independent central banks are an important part of this institutional structure. Far from calling into question or suspending that independence, this episode has called for a response from central banks that's only possible because their independence gives them the freedom to operate. As a result, they've made big decisions and implemented them rapidly in the face of an unparalleled crisis, coordinating with governments to maximize policy effectiveness. This capacity to act must be reinforced and not mistakenly called into question.
Second is the role of the central bank balance sheet. Central banks deployed a range of balance sheet tools at pace and scale as the crisis developed. Reserves — the deposits held at central banks — are the ultimate liquid assets. By acting as a buffer to meet the demand for greater liquidity in the face of a loss of economic confidence, as well as transmitting decisions on monetary policy, reserves can help prevent a problem of liquidity in markets becoming one of solvency in the wider economy.
But the role of central bank reserves shouldn't always be taken for granted. Rather than having to keep relying on central bank support for all aspects of the financial system, we need a robust assessment of the latter's weaknesses. The role of money market funds, and the risks to financial markets that they posed at the height of the disorder, is one area to examine.
Finally, the current scale of central bank reserves mustn't become a permanent feature. As economies recover, it's likely that some of the exceptional monetary stimulus will need to be withdrawn, including by reducing reserves. This wouldn't take us back to the very low levels of reserves before the financial crisis, which sometimes failed to recognize the role they play in ensuring the stability of the financial system. But elevated balance sheets could limit the room for maneuver in future emergencies. When the time comes to withdraw monetary stimulus, in my opinion it may be better to consider adjusting the level of reserves first without waiting to raise interest rates on a sustained basis.
Andrew Bailey, is governor of the Bank of England
Disclaimer: This opinion first appeared on Bloomberg, and is published by special syndication arrangement