The rich world’s central banks are on a new terrain

To flood the financial system with cash, the central banks print money and buy government and private bonds, increasing their total assets.

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As can be seen from the accompanying chart, the total assets of the US Federal Reserve were in the range of $700 billion-$900 billion in the years before 2008. In mid-September that year, the global financial crisis started with investment bank Lehman Brothers going bust and the world’s largest insurance company, AIG, having to be nationalized. Many other large financial institutions also had to be rescued by governments and central banks throughout the rich world.

To ensure that the US economy did not sink into a depression, the Fed started printing money and pumping it into the financial system by buying bonds. As a result, its total assets started to expand, peaking at $4.5 trillion by 2014.

In late 2019, the Fed started printing money and buying bonds again, even before the covid pandemic struck. As of 13 April, the total assets had gone up to around $9 trillion.

Interestingly, the gross domestic product or the size of the US economy as of 1 July 2008, before the full-fledged financial crisis broke out, stood at $14.9 trillion. More than 13 years later, as of 1 October 2021, the size of the US economy was at $24 trillion (in nominal terms, not adjusted for inflation). This means that the US economy expanded by 61% during this period.

In early July 2008, the total assets of the US Fed stood at $900 billion. By early October 2021, they had jumped to $8.5 trillion, jumping more than ninefold. Ideally, the size of a central bank’s balance sheet should expand in line with the size of the country’s economy. Clearly, that has not happened. This is visible in the case of other rich-world central banks as well.

Take the Bank of England. In July 2008, its total assets had stood at £94 billion. It expanded to more than £300 billion in 2015. Currently, it stands at around a trillion pounds. The size of the UK economy expanded by around 45% between 2008 and 2021. Even in the UK, the central bank’s total assets have grown much faster than the overall economy.

All this printed money floating around in the financial system has led to bubbles in stocks, real estate and crypto markets. It has also translated into unprecedented decadal-high inflation in the last few months.

Hence, the rich-world central banks now want to take out the money they had printed and pumped into the financial system by gradually selling the bonds they accumulated on their balance sheets over the years. The Bank of England has already started to do this. The US Fed plans to take out up to a trillion dollars through this fiscal by selling bonds.

Nonetheless, these are uncharted waters, with the central banks expanding their balance sheets for close to 14 years now. No one really knows the impact of this. Will this lead to interest rates going up too soon and too fast, triggering an economic recession in a world still trying to emerge from the aftermath of the pandemic? Will this ultimately lead to central banks stopping the withdrawal of printed money from the financial system? On that, your guess is as good as mine.