Central Bank Finances and Monetary Policy Conduct
December 12, 2023
Monetary Affairs Department
Bank of Japan
Abstract
Since the late 1990s, the Bank of Japan, faced with the zero lower bound on interest rates, has implemented various unconventional monetary policy measures. Major overseas central banks have also implemented large-scale asset purchases and other measures since the outbreak of the Global Financial Crisis. Given that such unconventional monetary policies accompanied by large-scale balance sheet expansions have the potential to have a large impact on central banks' finances when monetary policy is tightened, there has been debate on the potential impact on central banks' ability to conduct monetary policy and, by extension, confidence in their currencies.
Central banks earn interest income on the government bonds they purchase and short-term loans they provide, while their liabilities -- current deposits at the central bank (required reserves) and banknotes -- are not subject to interest. This structure usually allows them to generate stable profits (seigniorage).
When the central bank expands its balance sheet under unconventional monetary policy through, for example, the purchase of government bonds, this leads to increases in holdings of government bonds and other assets on the asset side and in current deposits (excess reserves) on the liability side. While the central bank needs to pay interest on excess reserves, since the interest rate on government bonds purchased usually exceeds the interest rate on excess reserves, interest income and other income increase in line with the rise in holdings of government bonds and other assets, so that the central bank's overall profits increase.
On the other hand, during a phase when monetary policy moves toward tightening and the balance sheet shrinks, holdings of government bonds will decrease on the asset side, while excess reserves will decrease on the liability side. When, during this phase, the central bank raises the interest rate on excess reserves, interest expenses will increase, putting downward pressure on its profits. Subsequently, however, interest expenses will decline as excess reserves decrease. Furthermore, since government bond holdings will be successively replaced by higher-yielding government bonds, interest income will increase. Therefore, while the central bank may temporarily make losses during this process, even if this occurs, profits will eventually recover.
The extent to which profits fluctuate during a phase of balance sheet contraction can differ substantially depending on factors such as (1) the size of the balance sheet, (2) the extent to which proceeds from the redemption of government bonds at maturity are reinvested, (3) developments in short-term and long-term interest rates, and (4) developments in banknotes in circulation.
Under a fiat money system, it is important to consider decreases in the central bank's profits and capital from the perspective of whether and how they affect the conduct of monetary policy. In this regard, there are two schools of thought: one is that they adversely affect monetary policy conduct, and the other is that they do not. There are also a variety of positions regarding the theoretical reasons underpinning these views.
Major overseas central banks have recently been tightening monetary policy rapidly and substantially in response to inflation, leading to decreases in their profits and capital. However, in their external communication, they have emphasized that even if they temporarily make losses or have negative equity, this will not impede their ability to conduct monetary policy. Moreover, these central banks have noted that, although their profits are currently decreasing, it is also the case that they increased during the past balance sheet expansion, and that assessments of their large-scale easing policies should focus on the positive effects on the economy overall. Against this backdrop, with a view to avoiding adverse consequences, such as doubts about their ability to conduct monetary policy and a decline in their credibility, these central banks, in recognition of the importance of central bank capital, have maintained their stance to work on restoring their capital over time. Under these circumstances, no particular impediments have arisen in any of the countries or regions in terms of ensuring confidence in their respective currencies through the appropriate conduct of monetary policy.
In light of the above, the relationship between central bank finances and monetary policy conduct can be summarized as follows.
Under a fiat money system, confidence in the currency is not directly ensured by the assets held by the central bank or its financial soundness, but by the appropriate conduct of monetary policy with the aim of achieving price stability. Based on this premise, central banks are generally set up in such a way that they make profits from a somewhat longer-term perspective and, moreover, can supply their own means of payment and settlement. Therefore, even if the central bank temporarily makes losses or has negative equity, this does not impede its ability to conduct monetary policy. That said, this does not mean that the central bank can run up unlimited losses and negative equity. If the central bank's financial risks become a matter of undue attention and give rise to unnecessary confusion over monetary policy, there is a risk that this could lead to a decline in its credibility. Therefore, ensuring the soundness of the central bank's finances is important.
The Bank of Japan deems it appropriate to continue with conducting appropriate policy while also paying attention to its financial soundness.
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