Monetary Crossroads: Central Bank Losses and the Way Forward

The large losses that central banks will suffer in the coming years will make monetary policy more difficult and complicated, according to former DNB president Nout Wellink and financial specialist David Marsh. This applies not only to the European Central Bank (ECB), but also to the Bank of England and the US Federal Reserve. Why is monetary policy becoming more complex and what can be done to alleviate the problems?

Quantitative easing

With interest rates raised sharply last year, it was reported that central banks are likely to do so in the coming years. are going to suffer a loss. This is because central banks will have to pay more interest on the reserves that commercial banks hold with the central bank. On the other side of the balance sheet are, among other things, the bonds that have been bought on a large scale in recent years during the central bank's purchase policy. The central bank then bought bonds to stimulate the economy. These bonds are now on the central bank's balance sheet and still carry the low interest rates from the time they were issued. This creates a mismatch and the difference goes down in the books as a loss for the central bank and therefore possibly also for the taxpayer.

In the article on the website of think tank IMFIF It is noted that governments can no longer ignore the central bank in the event of major crises. For example, the central bank, independent on paper, stepped in in previous crises to maintain stability. As a result, central bank balance sheets in many countries have grown enormously in size. For example, the Eurosystem's balance sheet total rose from 4700 billion to 8600 billion euros in a few years. Right away Quantitative Easing has stopped, the balance sheet total is falling again. There are now 7200 billion euros at the bottom of the Eurosystem's balance sheet.

The size of the Eurosystem's balance sheet total in recent years. (Source: OMFIF)

How bad are losses?

In 2022, the Dutch Central Bank suffered a loss of 460 million euros. There is still uncertainty about exactly how big the losses will be in the coming years. For example, a lot depends on the interest rate. It is possible that central banks will cut interest rates later this year if inflation continues to fall so sharply. For example, Dutch inflation was 'only' in August three percent. This is still slightly too high, but it is considerably better than the high price increase in September last year. Among other things, Base Effects are now driving down inflation. This means that the major price shocks mainly took place in the summer of 2022 and that the price increase after the summer of 2023 compared to a year earlier will therefore be lower. This creates room for the central bank to ease if the economy is in dire straits. In that case, central banks will also have to pay less interest to commercial banks.

Inflation has been falling for some time and reached three percent in August (Source: CBS)

In addition, the ECB announced in July that as of 20 September no more interest will be paid on the Minimum reserves, the reserves that commercial banks are required to hold with the central bank. This means that the central bank's interest charges will also be lower if that obligation lapses.

The ECB also does not value the entire balance sheet at market value. This means that a loss is only incurred on the purchased bonds if they were to be sold. Since market interest rates have risen and the price of the bonds purchased has fallen as a result, the losses would be much greater if the ECB were to value these bonds at market value. For example, the IMF calculated that such losses could have amounted to 758 billion euros at the end of last year. Unlike a commercial bank, the central bank cannot be forced to sell the bonds. Therefore, the central bank holds these bonds until they expire and the central banks suffer less loss than if these securities were valued at market value.

Finally, it is also true that a central bank is a special institution and by definition cannot go bankrupt. Although the institute is subject to all kinds of regulations, the institution is never short of what it can create itself; money. As a result, it is in principle also possible for central banks to operate with negative equity. Although there are already central banks in Eastern Europe operating with negative equity, negative equity would dent the confidence and credibility of the Dutch Central Bank.

However, the central banks also built up buffers in the years when profits were made. As a result, negative equity is out of sight for at least some time to come. For the Dutch Central Bank, this involved a buffer of 11.3 billion last year, Klaas Knot said in October last year. Buitenhof. Should the central bank's losses exceed its financial buffers, taxpayers may have to step in. On the other hand, of course, the state has also benefited from these operations in the years of the buy-back policy. Then central banks made profits. That amount was then paid to the State as a dividend. Klaas Knot estimated the profit for the state in recent years at 28 billion.

Difference Between Central Banks

The loss suffered by central banks is not the same for every country. Bonds of northern European countries suffer the biggest losses, as the Yield on bonds was lower than on Southern European bonds. Bonds have also been purchased on the basis of the distribution key, which is calculated on the basis of gross domestic product and population. For example, it can be seen that Germany suffers greater losses than France and Italy.

Losses by country. (Source: OMFIF)

Germany is therefore in a vulnerable situation. According to the IMF, the Bundesbank could start to make losses until 2026. Germany was also a sensitive country where the introduction of the euro was sensitive. The Bundesbank was one of the only central banks to give up monetary autonomy, as many central banks aligned policy for the euro with the Bundesbank. Now that a new point of disagreement may be on the horizon after the euro crisis and years of unconventional monetary policy, the debate about the euro could flare up again. On the other hand, it must also be said that the Netherlands and Germany are the countries that have also benefited the most from the euro in terms of the exports of both countries. The fact is, however, that policymakers are in for a difficult discussion and that quantitative easing is less likely to fall back on them in the future.

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On behalf of Holland Gold, Paul Buitink and Joris Beemsterboer interview various economists and experts in the field of macroeconomics. The aim of the podcast is to provide the viewer with a better picture and guidance in an increasingly rapidly changing macroeconomic and monetary landscape. Click here  to subscribe.