Monetary policy: from heterodox to orthodox

In a relatively brief amount of time, policies that once would have been anathema to any self-respecting central banker have become a standard part of the monetary policy tool kit. With the global economy flagging in the wake of the covid crisis and interest rates already at or below zero in much of the world, widespread asset purchases have become the only monetary game in town. In this Macro Flash Note Daniel Murray highlights the scale of asset purchases so far and also discusses by how much further they might rise. 


Prior to the Global Financial Crisis (GFC), central bank balance sheets expanded relatively slowly at a rate consistent with that needed to supply sufficient cash for transactions whilst also ensuring monetary policy objectives were met. However, when interest rates hit the zero lower bound during the GFC and with economies still struggling central bankers were prepared to try novel approaches to prevent the situation deteriorating. And so was born the policy of large scale asset purchases as a means of supporting economic activity. At the time such policies were labelled ‘unorthodox’. However, as more central banks have followed the same path and as the policies have persisted, asset purchases have become an integral part of the modern central banker’s suite of policy tools.

Chart 1. Central bank balance sheet expansion in 2020

Source: Federal Reserve, ECB, Bank of Japan, Bank of England, Eurostat, EFG calculations

As a result, the past twelve years have seen exceptional growth in central bank balance sheets. For example, in the first few years of the century prior to the GFC the Fed’s balance sheet expanded at an annualised average rate of less than 4%. Since the second quarter of 2008, it has expanded at an average annualised rate of 17.3% with a resurgence in growth this year – see Chart 1. Furthermore, the rate of expansion over the past 12 years is high in a longer term historical perspective, as shown in Table 1. The main reason why central bankers were reluctant to employ such polices in the past is that it was thought they would be highly inflationary. For reasons set out in a previous report this has not been the case1.

Table 1. Growth of the Fed’s balance sheet

Source: Federal Reserve, EFG calculations

A reasonable question to ask is: how much further can central banks go in expanding their balance sheets?

Balance sheets compared

Whilst there is no well determined theoretical basis for trying to assess what the limits might be, it is instructive to look to the Bank of Japan as an example of a central bank that has been engaged in asset purchases for some time, having first adopted the policy in 2001. There are number of different ways in which other countries might be compared to Japan in this regard:

i) Government debt owned by the central bank as a % of total government debt outstanding

ii) Government debt owned by the central bank as a % of GDP

iii) Central bank balance sheet size as % of GDP

Data pertaining to these three metrics is shown in Table 1.

Table 2. Various debt metrics

Source: IMF, Federal Reserve, Bank of Japan, Bank of England, Eurostat, EFG calculations

The Bank of Japan owns government debt equivalent to 95% of GDP, nearly 5x as great as for the US, a little over 4x as much as for the euro area and about 3.5x that for the UK. The proportion of government debt owned by the Bank of Japan is 52.1%, roughly 2.5x, 2x and 1.5x that for the US, euro area and the UK respectively. Central banks own assets other than governments bonds and these can constitute a significant part of the balance sheet. For example, the ECB’s Long Term Refinancing Operations are worth about half as much as the value of government bonds owned. Looking at total central bank assets to GDP shows that the Bank of Japan’s ratio is 3.7x, 2.2x and 3.3x that for the US, euro area and the UK respectively.

Whilst there may be good reasons why the effective limit on central bank asset purchases varies from one country or region to another, these numbers suggest that the Federal Reserve, European Central Bank and Bank of England all have significant space to increase their asset purchases should they want to do so. This would change if inflation started to pick up meaningfully above target but at the moment that seems highly unlikely.

A comment on sustainability

It used to be thought that government debt became unsustainable once the ratio to GDP surpassed about 90%2. However, Japan’s experience shows that need not be the case if you have a complicit central bank willing to make large scale asset purchases over a prolonged period of time. For the central banks studied here, all have made asset purchases via private markets and not from governments directly, so this is not monetisation. Government debt is sold to the private sector first from which the central bank eventually purchases it. This process is nonetheless helpful for government funding in three ways:

- By purchasing large amounts of government debt the central bank is ensuring that private sector agents will always be able to sell, ensuring that the government always has a ready market into which to sell its debt.
- Central bank actions keep interest rates low, thereby reducing the burden of servicing the debt.
- Central banks’ profits from bond holdings are typically returned to the treasury at the end of the year.

With regard to the second point, it is notable that, despite very large increases in the debt-to-GDP ratio, debt servicing costs remain very low and have even declined for some countries, as shown in Chart 2.

Chart 2. Net interest payments as % of GDP

Source: OECD, EFG calculations


Central banks have purchased a huge amount of government debt over the past 12 years since the start of the GFC. It used to be thought that this would be inherently inflationary and that in turn this would create a natural deterrent by pushing up bond yields and raising the nominal cost of government funding. However, it is now clear that the limits are much higher than previously thought, in particular in an environment where the economy is weak. This is in part due to the virtuous circle that is created when central banks buy government debt in size: a government issues debt (for example to fund crisis related expenditures); the central bank purchases debt from the market which helps to keep interest rates low; the government can afford to issue more debt because debt servicing costs are low and there is a liquid market. A challenge is that it becomes difficult for central banks to exit from asset purchases because it risks raising the cost of debt, something that may precipitate a growth slowdown. If Japan’s experience is a guide as to how far asset purchases could go in other countries, we should be grateful that there appears to be plenty of headroom.

1  See EFG Infocus Report “The Fed’s balance sheet and the missing inflation” by Stefan Gerlach, 16th June, 2020.

2  “Growth in a time of debt” by Carmen Reinhart and Ken Rogoff, American Economic Review, May 2010.