Not all central banks are created equal: the complications of QE bond buying.

• Author: Leppin, Marco

Following the failure of the Lehman Brothers investment bank and the global financial market crisis, the central banks of the United States, Japan, and the euro area launched several conventional and unconventional monetary policy measures in order to stabilize the financial system and cushion the severe economic slump.

They not only reduced interest rates to all-time lows but also pumped massive amounts of liquidity into the financial markets. This caused their balance sheets to expand considerably. The array of instruments used by these central banks included full allotment in refinancing operations or purchasing assets directly in the financial markets. With regard to nominal balance sheet expansion, it can be seen that the balance sheets of the Federal Reserve System and the Bank of England expanded to about five times their size prior to the financial crisis. The Eurosystem's consolidated balance sheet hit an all-time high following allotment of the second 36-month tender at the end of February 2012. Since the Eurosystem's balance sheet "only" doubled in size, this led to accusations that euro area central banks were not doing enough to fight the consequences of the financial and sovereign debt crisis and the economic downturn.

MATERIAL DIFFERENCES IN THE CONDUCT OF MONETARY POLICY

This simple comparison based on the original size of the balance sheet neglects two key points, however. One is that operational monetary policy in the United States is significantly different from that of the euro area. The other is that the various non-standard measures conducted in each currency area involve vastly different levels of risk.

Prior to the financial market crisis, the Fed conducted its monetary policy open-market operations in its "Primary Dealer System" with a group of only around twenty banks. The Fed has traditionally conducted its monetary policy operations with a comparatively small balance sheet. Following the Lehman Brothers collapse and the liquidity distress encountered by financial market participants, the Fed considerably expanded banks' access to central bank liquidity. Confidence among financial market participants soured severely and the interbank market broke down, to which the Fed responded by distributing liquidity centrally and becoming, for a time, the banks' most important counterparty. The rising number of transactions and direct liquidity supply caused the balance sheet to expand quickly from a low starting level.

The sudden growth of the Fed's balance sheet in September 2008 was due initially to its new temporary and more active role as a distributor of liquidity in the financial market. The subsequent balance sheet expansion was attributable to a total of three programs to purchase government bonds and mortgage-backed securities beginning in 2009.

By contrast, the Eurosystem has traditionally operated using a larger balance sheet within a bank-based system...