Get ready for interest rate normalization to shape central bank balance sheets to more traditional levels, achieving mean reversion after a significant trend of magnitude towards accommodation that has been historic in nature.
Goldman Sachs Group Inc (NYSE:GS) analysis didn't use the exact words, but they did note with this new “neutral” central bank balance sheets will be larger than before the 2008 financial crisis, will hold more duration and, as a result the yield curve could flatten as a “neutral” stance is achieved. The report interestingly pointed to an additional tool in the Fed tool kit should it be needed.
Goldman Sachs
Goldman Sachs: Get ready for normalization of monetary policy
“At the global level, monetary policy is set to normalise. This entails raising policy rates towards more ‘neutral' levels,” the report, written by Huw Pill's economics research team. Short-term interest rates are only one aspect of the monetary policy stance, they note, a departure from the financial crisis when central banks adopted a variety of non-standard policy measures, involving changes to the size and composition of their balance sheets.
Monetary policy normalization therefore will also entail re-shaping central bank balance sheets towards more neutral settings. The research report, titled “Defining the ECB's ‘neutral' balance sheet,” is quick to point out the benefits of significant leverage but not as quick on the risk disclaimer that might come with a larger balance sheet of sovereign debt, particularly in the emerging market. The report authors expect the “neutral” size of the balance sheet of a central bank such as the ECB to be higher after the crisis, and this, they opine, has several benefits:
(1) the central bank can deliver targeted ‘credit easing' measures aimed at specific impaired market segments without stimulating the broader economy through quantitative easing, allowing a more targeted policy response; and (2) policy responses would be more timely, as institutional concerns about balance sheet expansion will not slow down policy response via changes to balance sheet composition.
